FINANCIAL LEVERAGE

FINANCIAL LEVERAGE
There are
only two
things that
can be
done with
money –
spend it or
invest it.
WHAT IS LEVERAGE

 In physics, leverage denotes the use of a lever

and a small amount of force to lift a heavy
object.

 Likewise in business, leverage refers to the

use of a relatively small investment or a small
amount of debt to achieve greater profits.
FINANCIAL LEVERAGE

 The amount of debt used to finance

a firm's assets.
 A firm with significantly more debt
than equity is considered to be
highly leveraged.
 The degree to which an investor or
business is utilizing borrowed
money.

FINANCIAL LEVERAGE

 Companies that are highly leveraged may be

at risk of bankruptcy if they are unable to
make payments on their debt; they may also
be unable to find new lenders in the future.
 Financial leverage is not always bad,
however; it can increase the shareholders'
return on their investment and often there are
tax advantages associated with borrowing.
 Financial leverage tries to estimate the
percentage change in net income for a one
percent change in operating income.
 Its calculated as shown below.
 REVENUE-VARIABLE COST/OPERATING
INCOME.
HOW IT WORKS???

 When compared to the value of the property,

the amount of leverage increases as the
amount of borrowed funds increases, and
conversely, decreases when the amount of
borrowed funds decreases.
POSITIVE LEVERAGE

 The result of positive leverage is an increased

yield to the equity investor over the amount
that would have occurred without borrowing.
The investor benefits both from the
investment's yield on equity and from the
difference between the cost of funds and the
earnings on those borrowed funds for each
dollar borrowed. Therefore, in this case, an
investor can be making money on every
dollar borrowed.
NEUTRAL LEVERAGE

 Neutral leverage refers to an investment

situation where the cost of funds to the
investor is exactly equal to the yield of the
investment into which they are invested. In
this situation, the borrowed funds have no
effect on the yield to the equity investor, nor
does it change with the amount borrowed for
investment.
NEGATIVE LEVERAGE

 Negative leverage occurs when borrowed

funds are invested at a rate of return that is
lower than the cost of those funds to the
investor. The result of negative leverage is a
decreased yield to the investor over the
amount that would have occurred without
borrowing. Therefore, in this case, with
negative leverage, the investor is losing
money (return) on each dollar borrowed.
 In the financial world, leverage is the amount
of risk a person is willing to take. The greater
the risk, the greater the potential payoff. Of
course, the greater the risk the greater the
investor's chance of losing the investment
which is why not everyone uses financial
leverage and, of those who use it, why many
fail.
OPERATIONAL LEVERAGE

 The extent to which a business uses fixed

costs (compared to variable costs) in its
operations is referred to as "operating
leverage." The greater the use of operating
leverage (fixed costs, often associated with
fixed assets), the larger the increase in profits
as sales rise and the larger the increase in loss
as sales fall.
REVENUE-VARIABLE COSTS/OPERATIONAL
COSTS.
COMBINED LEVERAGE
 Combined leverage is the product of operating
leverage and financial leverage. It is a proxy for
the total risk of a company.
Combined leverage represents an important
principle of finance. As it is the product of
financial leverage and operating leverage,
companies should be reluctant to increase
financial leverage if the operating leverage is
already high. Conversely, companies with low
operating leverage (and therefore operating a
stable business) can afford to be more highly
geared.
ADVANTAGES OF FINANCIAL
LEVERAGE
 There are also advantages: "Financial
leverage is not always bad, however; it can
increase the shareholders ' return on their
investment and often there are tax
advantages associated with borrowing."
DISADVANTEDS OF FINANCIAL
LEVERAGE
 The disadvantages of financial leverage are
explained in this sentence: "Companies that
are highly leveraged may be at risk of
bankruptcy if they are unable to make
payments on their debt ; they may also be
unable to find new lenders in the future".
POPULAR RISKS

 There is a popular prejudice against leverage

rooted in the observation that people who
borrow a lot of money often end up badly.
But the issue here is those people are not
leveraging anything, they're borrowing
money for consumption.
 In finance, the general practice is to borrow
money to buy an asset with a higher return
than the interest on the debt. That at least
might work out. People who consistently
spend more than they make have a problem,
but it's overspending (or under earning), not
leverage. The same point is more
controversial for governments.
Leverage and the financial
crisis of 2007-2009
 Consumers in the United States and many
other developed countries borrowed large
amounts of money, $2.6 trillion in the United
States alone. For most of this, “leverage” is a
euphemism as the borrowing was used to
support consumption rather than to lever
anything. Only people who borrowed for
investment, such as speculative house
purchases or buying stocks, were using
leverage in the financial sense.
CONCLUSION

People sometimes
borrow money out of
desperation rather than
calculation. That also
is not leverage
REFERENCES

 http://ezinearticles.com/?Understanding-the-
Three-Types-of-Financial-
Leverage&id=4463375
 http://www.investopedia.com/terms/l/
leverage.asp
 http://www.referenceforbusiness.com/
encyclopedia/Kor-Man/Leverage.html
 http://www.vernimmen.com/html/glossary/
definition_combined_leverage.html