Financial Leverage

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, thefinancial 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.

Along with maintaining a favorable ratio, it is also important to measure the degree of financialleverage 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.