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A company or institution can use its own funds plus borrowed funds for investment. This is also known as leverage capital. As long as the capital (owned assets), plus the borrowed funds are invested as a rate of return higher than the interest on the borrowed funds, the company or institution makes money. The ratio of borrowed funds to the investor's own funds is the leverage ratio.
A simple example of using leverage capital is the business of a bank. A bank acts as a financial intermediary. Bank depositors and shareholders provide the capital. The bank loans the capital out to qualified borrowers. As long as the rate of interest paid by borrowers exceeds the rate of interest that the bank has promised to depositors, then the bank realizes a profit.
Commercially insured banks have average leverage ratios of 15 to one. Their leverage ratios are typically much higher than that of corporations because banks are in business to provide leverage capital for others. Although required to have certain reserves, banks typically make money by loaning money at interest. Banks protect themselves by tightening their lending practices to diminish the possibility of loan defaults.
Financial leverage is also referred to as trading on equity. The ratio of financed debt to equity (leverage ratio) is an important statistic to determine the health of a company. Higher leverage ratios make it important to understand the risk level of the company’s investments. If a company uses leverage capital, the potential returns and losses are magnified.
A company will leverage its equity because it gives the company the potential of a greater return on its funds. Leverage ratios for businesses are much lower than those for banks. If a company has $200,000 US Dollars (USD) in capital and borrows $400,000 USD, the leverage ratio is two to one. If the company invests $600,000 USD, then the return on the investment needs to be at a higher percent than the company owes the bank. A bank loan at five percent would require an investment return of more than five percent to be profitable for the company.
The net between the loan interest and the investment return is magnified by the leverage ratio. If a corporation borrows funds at five percent and has a return of ten percent the interest owed would be $20,000 USD. The total return on its investment would be $60,000 USD. Once the loan is repaid the corporation would have a $40,000 USD increase in its equity.
When the return is lower than the loan interest rate, using leverage capital can decrease the total equity a corporation has. If the investment return above had only been four percent, then the total return would have been $24,000 USD. The increase in equity is minimal. At a three percent, return the corporation begins to lose equity. The use of leverage capital needs to be weighed against all risk factors. Corporations exercise caution and due diligence in choosing investments for leveraged funds.