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Hey everyone 👋🏼
“Leverage”.
Possibly one of the more complex concepts to understand, which is odd given it shapes the financial world around us.
I think most of the confusion might even stem from the word itself and the contrasting meanings embedded in the word.
For some, when they think of leverage, they think “power and effectiveness”. But in a financial context, leverage refers to this:
“the use of credit to enhance one’s speculative capacity.”
So whilst these are some of the definitions according to the dictionary, that doesn’t shed a great deal of light on what on earth financial leverage is actually all about.
“When you combine ignorance and leverage, you get some pretty interesting results.”
Warren Buffet
Today I’ll cover:
A quick explanation of financial leverage 💨
Who uses leverage and for what reasons? 🧑🏻💻
📹 explanation…in 26 seconds.
A (simple) example of leverage being used in the stock market
What is a financial leverage ratio and why is it important?
How a trader lost $20 billion from using borrowed money 😬
Tools and resources 🧰
Let’s jump in!
(Quickly) Explained…
Leverage is basically debt.
More specifically, leverage is when you borrow money (rather than use just your own money) to undertake an investment, project, or acquisition.
If you bought a house via mortgage, then that house is leveraged.
Leverage has higher potential gains than only using your own money, but it also has higher risks.
If the post-tax profit exceeds the borrowing costs, then leverage is a useful tool. If the asset's value falls or it fails to generate enough income to cover the financing costs, then the leverage can multiply the losses.
Who uses leverage and for what reasons? 🧑🏻💻
Financial leverage is used by various individuals and entities, including individuals, companies, and investors. Here are a few examples:
🧍🏼♀️Individuals: Individuals may use financial leverage when purchasing a home through a mortgage. By borrowing money from a bank, they can own a property that they wouldn't be able to afford with just their savings. They benefit from the potential appreciation of the property's value, but they also carry the risk of losing their investment if the property value decreases.
🏢 Companies: Companies often use financial leverage to finance their operations and expansion. They can obtain loans or issue bonds to raise capital for investments, such as acquiring new assets, expanding their facilities, or developing new products. By using leverage, companies can potentially generate higher returns on their investment than the cost of borrowing. However, it also exposes them to greater financial risk if their investments do not yield expected returns.
💼 Investors: Investors, such as individuals or investment firms, use financial leverage in various forms. In stock market investing, for example, investors can engage in margin trading, where they borrow funds from a brokerage firm to buy more shares than they could with their own capital. This allows them to potentially amplify their profits if the stock price rises. However, it also magnifies their losses if the stock price falls.
💵 Private equity and venture capital firms: These firms use financial leverage to acquire ownership stakes in companies. They often combine their own funds with borrowed capital to finance the purchase of a company or to support its growth. By using leverage, these firms aim to enhance their returns when they eventually sell their stake in the company.
Leverage…in 26 seconds:
Stock trading using leverage - a quick example 🗒️
Let’s say you have $10,000 in your brokerage account and want to invest in Company X.
X is currently trading at $50 per share.
If you purchased shares with just the cash you have, you could afford 200 shares. If you decide to use leverage, borrowing $10,000 from your broker (note: each broker has different lending criteria), you could buy 400 shares instead.
This amplifies your potential gains and losses.
If the share price rises to $60, you’d earn a profit of $2,000 or 20% if you invested with cash. If you used leverage, you’d earn $4,000 or 40% of the cash you invested.
However, if the price dropped to $40, you’d lose $2,000 with a cash investment and $4,000 if you invested using leverage.
Remember: You have to pay back the money you borrow from your brokerage.
You’d lose all of the money you invested if you used leverage and the stock price of Company X fell to $25. You’d owe money to the broker even after selling your shares if the price fell below $25.
A quick side note: if you’re interested in exploring alternative investment opportunities and side hustles, paid subscribers also get access to The Alternative Assets Series.
What is a financial leverage ratio and why is it important? 🧐
A financial leverage ratio is a measure of a company's use of debt to finance its operations. It compares the company's total debt to its equity, and is used to assess the risk of the company's financial structure.
A high leverage ratio indicates that the company is heavily reliant on debt to finance its operations, which can increase the risk of financial distress if the company is unable to meet its debt obligations.
A low leverage ratio, on the other hand, suggests that the company is less reliant on debt and may be less risky.
Financial leverage ratios are used by investors and creditors to evaluate the risk of a company's financial structure and to determine the company's creditworthiness.
Losing $20 billion in two days 🫠
For an insight on how leverage can play out in the real world, look no further than the case of Bill Hwang.
The story of the now-notorious owner of Archegos Capital Management who took extraordinary risks by leveraging stock positions and artificially inflating their prices is one that makes you question the very concept of leverage.
I’m sure there will be a HBO or Netflix show on this very soon, but in the meantime, here’s a great summary of this insane story!
Resources, tools and further reading 🤓
Here’s a bit more reading and some tools if you want to dig around this topic a bit more:
Seth Godin’s ‘Leverage is Brittle’
Thank you very much for reading 🙏 if you found this helpful and enjoyed the post, I’d be super grateful if you could hit the ❤️ below - thank you!
DISCLAIMER: None of this is financial advice. Concepts of Finance newsletter is strictly for educational purposes.