Leverage

What is leverage?

Leverage is the ability to control large dollar amounts of a commodity or security with a comparatively small amount of capital. (Source: CFTC)

Leverage (or gearing) is using given resources in such a way that the potential positive or negative outcome is magnified. In finance, this generally refers to borrowing. If the firm's return on assets (ROA) is higher than the interest on the loan, then its return on equity (ROE) will be higher than if it did not borrow. On the other hand, if the firm's ROA is lower than the interest rate, then its ROE will be lower than if it did not borrow.

Financial leverage takes the form of a loan or other borrowings, the proceeds of which are reinvested with the intent to earn a greater rate of return than the cost of interest. Leverage allows greater potential return to the investor than otherwise would have been available. The potential for loss is greater because if the investment becomes worthless, not only is that money lost, but the loan still needs to be repaid. Margin buying is a common way of utilizing the concept of leverage in investing. An unlevered firm can be seen as an all equity firm, whereas a levered firm is made up of ownership equity and debt. A firm's debt to equity ratio (measured at market value, not book value) is therefore an indication of its leverage. Degree of financial leverage (DFL) may be defined as the percentage change in earnings (EPS) that occurs as a result of a percentage change in earnings before interest and taxes. (Source: Wikipedia)

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