What is leverage?
Leverage is when a person or entity uses different financial instruments or borrows capital to increase the possible return of the investment. A company or person who has more debts or loans than equity is referred to as highly leveraged.
The term is widely used for real estate deals since mortgages are used to buy a home.
Explanation of leverage
There are different ways to create leverage which include futures margin, options as well as other financial instruments.
For example, a person or company that has $1000 that can be used for investment can opt to buy 10 shares of Apple stocks. But the person or company may also choose to invest the $1000 in five other options contracts, and this means that the person or company will control 500 shares rather than just 10.
Other firms also choose to get a loan to finance their needs. This means that the entity has increased its leverage since the loan can finance the business operation, but the firm did not need to increase the equity.
For example, a company that was created with $4 million that came from investors will have $4 million as its equity which is the amount that will be used for operations. If the firm opts to take a loan and borrows $10 million, and then, the firm will have $14 million that can be used to invest in the operations of the firm.
Leverage aids not just the investor, but also the firm to make their investments as well as to operate. But the leverage comes with some risks. For example, a firm makes use of leverage to invest, but then the investment does not turn out to be profitable. The firm will incur losses since it has to pay interests for an investment that did not bring profits.