Leverage

Leverage is a term used to describe the ratio of debt to equity (in other words, the ratio between debt and equity). 

Leverage explained

Usually when calculating this ratio, the total amount of liabilities, including both short-term and long-term liabilities, is considered. Sometimes only the sum of long-term liabilities is used. If the ratio is less than 1, it means that the company's assets are mostly financed by equity. If the leverage ratio is more than 1, then the company's assets are financed more by debt.

Also leverage or the effect of leverage is the effect of using borrowed capital to increase the size of operations and profits without having sufficient capital to do so. The size of the debt to equity ratio characterizes the degree of risk, financial stability.

Financial leverage can occur only if a trader uses borrowed funds. The cost of debt capital is usually lower than the additional profit it provides. This extra profit is added to the return on equity, thus increasing its profitability.

Low leverage ratios are preferable for lenders because lenders are better protected in the event of a borrower's bankruptcy. From the shareholders' (business owners') point of view, high leverage values are preferable, which increases the return on investment.

Margin Leverage requirements

At commodity, stock and currency markets the term "financial leverage" is transformed into margin requirements - percentage ratio of funds, which a trader is obliged to have on his balance for conclusion of a deal to the total value of the concluded deal. Usually at commodity market the security of not less than 50% of the total sum of transaction is required, i.e. in order to conclude a contract for 100 dollars a trader must possess not less than 50 dollars. At the derivatives market or currency exchange market conclusion of, for example, futures contract requires making a guarantee in the amount from 2 to 15 per cent of the contract value, i.e. in order to conclude a contract for 100 dollars it is enough to possess from 2 to 15 dollars.

In margin trading, leverage is often written as a proportion, which shows the ratio of the amount of collateral to the size of the possible contract. For example, a 20% margin requirement corresponds to a leverage of 1:5 (one to five) and a 1% margin requirement corresponds to a leverage of 1:100 (one to one hundred). In this case it is said that a trader can conclude a contract 5 (or 100) times the amount of his/her margin deposit.

Components of the Leverage

Financial leverage demonstrates the presence and level of independence from creditors;

A large share of borrowed capital in the total structure of the latter indicates a high level of financial leverage, and thus a low financial independence of the firm;

Replenishment of credit portfolio is in direct dependence on the growth of financial leverage, and hence on possible financial problems;

The problem may be that no one cancelled regular payments on financial liabilities, and in the absence of a source of repayment, that is EBIT, the question may arise of the inevitability of the sale of some assets;

For an organization with a high leverage ratio, even a small change in EBIT can have a big impact on net income.