Financial Leverage
Financial Leverage: Financial leverage is a leverage created with the help of debt component in the capital structure of a company. Higher the debt, higher would be the financial leverage because with higher debt comes the higher amount of interest that needs to be paid. Leverage can be both good and bad for a business depending on the situation. If a firm is able to generate a higher return on investment (ROI) than the interest rate it is paying, leverage will have its positive effect shareholder’s return. The darker side is that if the said situation is opposite, higher leverage can take a business to a worst situation like bankruptcy.
Financial Leverage = Total Debt/Shareholders equity
The most well known financial ratio is debt to equity ratio.
Let's use the stock margin account as an example: * You have $5000 to invest in a stock * You buy 100 shares of a $50 stock in a cash account ($5000) and the stock goes to $55 ($5500)-- you're up $500 or 10% * Now we are going to use leverage-- a margin account to buy the stock * You buy 200 shares of the same $50 stock in a margin account ($10000 = $5000 your cash + $5000 borrowed) and the stock goes to $55 ($11000)-- you're up $1000 or 20% (not counting the cost of the margin interest). Margin (or leverage) magnifies your gains.
Now let's look at it the other way around . . . * You have $5000 to invest in a stock * You buy 100 shares of a $50 stock in a cash account ($5000) and the stock goes to $45 ($4500)-- you're down $500 or 10% * Now we are going to use leverage-- a margin account to buy the stock * You buy 200 shares of the same $50 stock in a margin account ($10000 = $5000 your cash + $5000 borrowed) and the stock goes to $45 ($9000)-- you're down $1000 or 20% (not counting the cost of the margin interest). Margin (or leverage) magnifies your losses.
As you can see from this little example, leverage is wonderful in the case of rising prices,but not so
Financial Leverage = Total Debt/Shareholders equity
The most well known financial ratio is debt to equity ratio.
Let's use the stock margin account as an example: * You have $5000 to invest in a stock * You buy 100 shares of a $50 stock in a cash account ($5000) and the stock goes to $55 ($5500)-- you're up $500 or 10% * Now we are going to use leverage-- a margin account to buy the stock * You buy 200 shares of the same $50 stock in a margin account ($10000 = $5000 your cash + $5000 borrowed) and the stock goes to $55 ($11000)-- you're up $1000 or 20% (not counting the cost of the margin interest). Margin (or leverage) magnifies your gains.
Now let's look at it the other way around . . . * You have $5000 to invest in a stock * You buy 100 shares of a $50 stock in a cash account ($5000) and the stock goes to $45 ($4500)-- you're down $500 or 10% * Now we are going to use leverage-- a margin account to buy the stock * You buy 200 shares of the same $50 stock in a margin account ($10000 = $5000 your cash + $5000 borrowed) and the stock goes to $45 ($9000)-- you're down $1000 or 20% (not counting the cost of the margin interest). Margin (or leverage) magnifies your losses.
As you can see from this little example, leverage is wonderful in the case of rising prices,but not so