Understanding Leverage

Give me a place to stand, and a lever long enough, and I will move the World

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You probably have heard the term leverage and wondered what does it mean in the world of finance.

It is also very likely that you are familiar with the negative connotation that is associated with the risks of leverage, or you might have even heard of the benefits, and there are.

Leverage refers to the use of debt in order to maximize results or returns.

Consider the balance sheet of a company, on its left side we find the Assets, and on the right side the Liabilities and Equity. In other words, the left side shows “What we have” and the right side depicts “how we got it” or “to whom we owe it”.

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We must keep in mind that by construction the sum of assets must be equal to the sum of liabilities plus equity.

What is the advantage of using leverage?

One of its upsides is that with less capital we can access a larger amount of assets, preferably productive.

What are the main characteristics of debt?

We can identify a liability when we are required to pay certain amount (principal) plus an interest (rate) in a defined time span (term).

If the return we obtain from the assets is higher than the interest required by the debt, we will have enhanced our profits.

If our assets can give us a 15% annual return, and the interest we pay on the debt is 10% we are getting 5 extra cents for each dollar of debt, plus 15 cents for each dollar of equity. Our return on equity (ROE) would behave as follows at different levels of leverage.

leverage table
A 9.0x leverage enhances our ROE up to 60%. Not too shabby.

Now, it would seem a great idea to use leverage as a tool to boost a company’s returns.

What could possibly go wrong?

Well, we know that the assets of a company may be subject to changes in its valuation, what happens if a building falls, accounts receivable are determined as uncollectible, or simply our inventory becomes obsolete?

Our creditors are indifferent to these aspects, if we owe them 100 dollars, they will demand 100 dollars. Therefore, these adverse effects should be reflected in our equity. What is the sensitivity that our equity has depending on the leverage?

leve gif3.gif

How does this apply to our daily life?

Let’s assume that you acquired a mortgage and made a 20% down payment and you owe the rest to the bank (debt). This is a leverage of 4.0x, what draw down on the housing market prices would impact or erase your equity? According to the above table, a 20% drop would wipe out your initial investment. Although we can classify this as probable, not impossible, 10 years ago the US home prices witnessed adjustments of up to 40%, and people were buying homes with negligible or null down payments.

Furthermore, there were financial institutions — with a leveraged capital structure in the double-digit neighborhood by nature — that purchased these mortgages (accounts receivable) a recipe that complicated the situation down the road.

Final thoughts

There are investors who use leverage to maximize returns, as in FX markets or derivatives. Nowadays, there are controls to limit losses, although they mostly consist of preventing the loss from exceeding the contributed equity. That is, the maximum loss may be the total of your contributed equity, but you can avoid incurring in additional obligations past that threshold.

All in all, leverage is a tool, which used properly can help maximize returns, but it can increase risk exponentially if it is not handled appropriately. Used in a responsible way, it has proved to be a very useful tool… and it has in fact moved the financial world.

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