Finance, leverage is a general term for any technique to multiply gains and losses.Common ways to attain leverage are borrowing money, buying fixed assets and using derivatives.
A public corporation may leverage its equity by borrowing money. The more it borrows, the less equity capital it needs, so any profits or losses are shared among a smaller base and are proportionately larger as a result.
A business entity can leverage its revenue by buying fixed assets. This will increase the proportion of fixed, as opposed to variable, costs, meaning that a change in revenue will result in a larger change in operating income.
Hedge funds often leverage their assets by using derivatives. A fund might get any gains or losses on $20 million worth of crude oil by posting $1 million of cash as margin.
Measuring leverage
A good deal of confusion arises in discussions among people who use different definitions of leverage. The term is used differently in investments and corporate finance, and has multiple definitions in each field.
Corporate finance
Accounting leverage has the same definition as in investments. There are several ways to define operating leverage, the most common.
Financial leverage is usually defined:
Operating leverage is an attempt to estimate the percentage change in operating income (earnings before interest and taxes or EBIT) for a one percent change in revenue.
Financial leverage tries to estimate the percentage change in net income for a one percent change in operating income.
The product of the two is called Total leverage, and estimates the percentage change in net income for a one percent change in revenue.
There are several variants of each of these definitions, and the financial statements are usually adjusted before the values are computed. Moreover, there are industry-specific conventions that differ somewhat from the treatment above.
A public corporation may leverage its equity by borrowing money. The more it borrows, the less equity capital it needs, so any profits or losses are shared among a smaller base and are proportionately larger as a result.
A business entity can leverage its revenue by buying fixed assets. This will increase the proportion of fixed, as opposed to variable, costs, meaning that a change in revenue will result in a larger change in operating income.
Hedge funds often leverage their assets by using derivatives. A fund might get any gains or losses on $20 million worth of crude oil by posting $1 million of cash as margin.
Measuring leverage
A good deal of confusion arises in discussions among people who use different definitions of leverage. The term is used differently in investments and corporate finance, and has multiple definitions in each field.
Corporate finance
Accounting leverage has the same definition as in investments. There are several ways to define operating leverage, the most common.
Financial leverage is usually defined:
Financial leverage tries to estimate the percentage change in net income for a one percent change in operating income.
The product of the two is called Total leverage, and estimates the percentage change in net income for a one percent change in revenue.
There are several variants of each of these definitions, and the financial statements are usually adjusted before the values are computed. Moreover, there are industry-specific conventions that differ somewhat from the treatment above.