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What is Leveraged Equity?

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  • Written By: K.M. Doyle
  • Edited By: W. Everett
  • Last Modified Date: 27 November 2016
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Leveraged equity is the stock of a company that has significant debt, which is also known as leverage. Because the company operates primarily by using debt, leveraged equity carries more risk than traditional equity. Depending upon the amount of leverage a company has, it can be as risky as debt. The risk lies in the company’s ability to finance the debt. If the debt cannot be financed from operations, either because sales decline or costs go up, the company will go bankrupt.

Companies use financial leverage in order to increase value for their shareholders. By borrowing money, a company can often obtain more capital than it would be able to obtain if it were to try to sell more shares of stock. If a company takes on too much debt, however, it risks seeing its stock price decline because of the belief that the company is over-leveraged, or has too much debt. It is a balancing act for companies to carry sufficient debt to expand their operations, while not acquiring so much debt that the company appears to be unstable.

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If a company wants to acquire another company, it would be quite difficult and time consuming for most companies to raise enough money through equity. Most companies will borrow the money needed to finance the acquisition. This is known as a leveraged buyout. Most leveraged buyouts are financed by 10 percent equity and 90 percent debt, or leverage. Bonds that are used to finance a leveraged buyout are quite risky, and are sometimes referred to as junk bonds. The stock in such a company would be considered leveraged equity.

Mutual funds can also take advantage of leveraged equity to increase their returns. Most investors would expect to find leveraged mutual funds in relatively volatile asset categories such as small- to mid-cap growth funds, but leverage can be used in funds of any class, including bond funds. These funds can increase return if the fund performs well, but investors can also suffer significant losses if the fund declines.

Individual investors can also use leverage to increase their buying power. When an investor purchases stock on margin, he is borrowing the funds from his broker to make the purchase. This is considered to be leverage. Options are also a use of leverage by the individual investor. Because any kind of leverage is risky, leverage should be viewed as a kind of supplement investment, and not as the predominant investment type in an investor’s portfolio.

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bagley79
Post 4

@sunshined - I would just encourage you to use caution if you open up a margin account. Yes, you definitely have more leverage to work with, but this can work against you just as quickly as working for you.

If you make some bad investments, and the price of the stock declines, you may have to come up with some extra capital. It is never fun to get a margin call or a maintenance call from your brokerage company.

There are certainly advantages when it comes to leveraging your investment money, but I would make sure this is money that you could stand to lose.

I have a margin account that I use sparingly, and never use for

long term trades. These are for quick trades and money that I know could work against me in a hurry.

If you are thinking about trading options, I would also start out small. Trading options can be exciting, but they are also quite risky. The time factor is always working against you, and you need to be vigilant when you make that investment.

On paper it all looks easy and exciting, but when you realize you don't have any control over what the stock is going to do, it helps keep the big picture in perspective.

sunshined
Post 3

I find that I am fascinated by using leverage when it comes to investing. I have an investment account with an online brokerage company and like to trade stocks and invest in mutual funds.

I have been thinking about opening up a margin account and buying options. With the company I use, you are required to have a margin account to trade options.

You can also trade regular stock with a margin account, and would usually have twice as much money to work with. If I opened a margin account with $5000, then I should have $10,000 to trade with.

It seems like you would really be able to make a lot more money in a shorter amount of time if you leveraged your money that way.

Mykol
Post 2

@John57 - I have worked for an investment company in the past, and you would be surprised at how many people invest in companies with a significant amount of leveraged capital.

Many times clients would come to our firm and not really even know what they were invested in. Their funds would be decreasing and they would wonder why.

I think many people don't take the time to fully understand their investments. On the other hand, I have seen customers who like the risk that goes along with this type of investment.

Generally, the greater the risk, the greater your chance of return. This is something that can entice even the most seasoned investors. The chance to make a large amount of money on a small investment is too easy to pass up many times.

John57
Post 1

I am just learning about investments and how to trade stocks. I think investing in a company that has a lot of debt would be a very risky investment.

For someone who doesn't have much money to invest in the first place, this would not be a very good place to put your money. Even the name 'junk bond' sounds like something you should stay away from.

The only way I think I would feel comfortable investing in a company with much leveraged equity would be through a mutual fund. I think the debt to equity ratio leverage would be spread out more when it was combined with several other funds.

Either way, this doesn't sound like something that would be for me. I work too hard for my money to invest it in a company that has too much debt and ends up going bankrupt.

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