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What is Financial Leverage?

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  • Written By: Malcolm Tatum
  • Edited By: Bronwyn Harris
  • Last Modified Date: 12 July 2014
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    Conjecture Corporation
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Financial leverage is a process that involves borrowing resources that are paired with existing assets and utilized to bring about a desired outcome to a financial deal. In some cases, the financial leveraging is used to enhance the chances for increasing the return earned on equity or some type of investment in the stock market. At other times, the strategy may be used as a means of blocking a specific outcome that could be detrimental to the investor in the long run.

As part of the process of leveraging, the borrowing can take on several forms. Obtaining loans for additional cash resources may be one means of initiating a leverage strategy. Purchasing debt, such as in acquiring the mortgage of a competitor, is another means of gaining some degree of leverage in a given business move. Trading investments on the margin extended to an investor by a brokerage firm can also be viewed as a form of financial leverage.

The degree of financial leverage required to achieve the desired outcome will vary, based on several factors. First, there is the relationship between the assets in hand and the amount of the loan or acquired debt that is needed to successfully execute the deal. This is a key element, as an unfavorable financial leverage ratio between assets and loans or debt may put the entire strategy at great risk and create severe financial hardship in the event that the deal does not go as planned.

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Along with maintaining a favorable ratio, it is also important to measure the degree of financial leverage inherent in the proposed deal. The best way to understand what is meant by degree as it relates to leverage is projecting the percentage change in the amount of earnings that is gained or lost on each share or unit involved with the deal. This degree is calculated before any applicable interests or taxes are accounted for, rather than afterward.

Operating financial leverage is another factor to consider. In its broadest application, this factor has to do with the positive or negative impact that the leveraging process is likely to have on the general operation of the entity that is initiating the proposed strategy. In terms of an individual investor, it is important to consider whether or not the leveraging process will temporarily inhibit the usual financial operations of the individual, or whether he or she can continue to function financially without making any changes or concessions.

The focus of any type of leveraging is usually to better the financial position of an individual or entity in some way. Often, the approach is employed when there is a very good chance at success and that success can be significantly increased in terms of a return by augmenting existing resources with others that are borrowed for the short term. As with any type of financial growth strategy, it is a good idea to investigate the potential outcomes of any financial leveraging strategy before engaging the strategy. This means looking at worst case scenarios as well as what gains could be achieved under the best of circumstances.

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Discuss this Article

BambooForest
Post 2

Any business dealing involving buying another company's assets, be they debt, mortgage, or capital, can be tricky. But I suppose in the business world, that's part of the point.

surfNturf
Post 1

Whenever I think of high financial leverage deals I always think of Bank of America buying out Countrywide in 2008. Bank of America’s financial leverage deal with Countrywide was an effort for Bank of America to finally own the mortgage market.

However, as a result of poor performing loans and foreclosure litigation this aspect of Bank of America’s business has not turned a profit in three years.

To make matters worse they lost close to $5 billion dollars last quarter and their stock price has dipped to only $14 a share. If this isn’t negative financial leverage, I don’t know what is.

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