What Is Business and Financial Leverage?
Written by Eddy Hood
When talking about real estate, investments, and/or starting a business, you may hear two commonly used accounting terms: return on investment (or ROI) and financial leverage. Many people know what ROI is; it refers to the money or capital gained back after investing in something. However, financial leverage is less used in everyday speech. What is leverage in finance, and what does it refer to? Leverage often refers to something that can be used to maximum advantage. In a mechanical system, you’re often using an object (the lever) to lift, pull, or move something. In accounting, you’re using debt to have a financial advantage.
What Is Leverage in Finance?
Financial leverage refers to a technique that involves using debt in the hopes of increasing a potential return on investment. In other words, it involves multiplying gains and losses by taking certain risks. Consider the following fictitious example: Sally, who sells seashells, is considering buying a home that’s close to the seashore. She has two options available to her:
- She could buy a $10,000 shack, which she can pay for in full with cash.
- She could buy a $50,000 shack, which she can pay $10,000 for in cash and then borrow $40,000 more.
It’s in the latter situation that she would be using financial leverage. Business decisions like this seem risky: What if she doesn’t pay the $40,000 back? They are risky. However, if she were to sell the property a few years later and her shack increased in value, that would lead to a greater return on her investment.
- Let’s say that the $10,000 shack increases in value 10%, making it now worth $11,000. She’d gain $1,000 back after her $10,000 investment (a 10% return).
- Let’s say that the $50,000 shack also increases in value of 10%, making it now worth $55,000. She’d gain $5,000 using her $10,000 investment (a 50% return).
By taking a risk, she got a higher return using leverage. Accounting for that increase in value means that everything will go well. What happens if it doesn’t?
- Let’s say that the $10,000 shack decreases in value by 10%, making it now worth $9,000. She’d lose $1,000 after her $10,000 investment (a 10% loss).
- Let’s say that the $50,000 shack decreases in value 10%, making it now worth 45,000. She’d lose $5,000 of her $10,000 investment (a 50% loss).
In simple terms, you could win more or you could lose more by using financial leverage. As financial leverage increases, so do the risks.
When Should Financial Leverage Be Used?
This is one of the ultimate questions in finance. Leverage, to answer this question simply, should only really be used when appreciation is very likely or even assumed. That’s why this term is most often used in real estate, as real estate prices are fairly consistently on the rise. If an industry is high-risk or involves property that’s likely to depreciate, using large sums of borrowed money is not likely to be beneficial.
Many small-business owners have questions about whether or not to use leverage. Business professionals can get real accounting advice from outsourced bookkeeping professionals, like those here at Ignite Spot. By contacting our firm, you can get online accounting and consultation services, enabling you to make sound financial decisions. Feel free to contact us, or download our free pricing guide now!