Definition of Leverage
he use of debt financing.
The relationship between interest bearing debt and equity in a company(financial leverage) or the effect of fixed expense on after tax earnings(operating leverage).
The use of debt financing.
The amplification of the return earned on equity when an investment or firm is financed
partially with borrowed money.
a factor that indicates how a percentage change in sales, from the existing or current
level, will affect company profits; it is calculated as contribution
margin divided by net income; it is equal to (1 - margin of safety percentage)
Percentage change in profits given a 1 percent change in sales.
Use of debt to increase the expected return on equity. Financial leverage is measured by
the ratio of debt to debt plus equity.
The equity (ownership) capital of a business can serve
as the basis for securing debt capital (borrowing money). In this way, a
business increases the total capital available to invest in its assets and
can make more sales and more profit. The strategy is to earn operating
profit, or earnings before interest and income tax (EBIT), on the capital
supplied from debt that is more than the interest paid on the debt capital.
A financial leverage gain equals the EBIT earned on debt capital
minus the interest on the debt. A financial leverage gain augments earnings
on equity capital. A business must earn a rate of return on its assets
(ROA) that is greater than the interest rate on its debt to make a financial
leverage gain. If the spread between its ROA and interest rate is unfavorable,
a business suffers a financial leverage loss.
Debt financing amplifies the effects of changes in operating income on the returns to stockholders.
A group of investors who have a preference for investing in firms that adhere to
a particular financial leverage policy.
Related: capitalization ratios.
Bank loan to a highly leveraged firm.
Idea that as long as individuals borrow (or lend) on the same terms as the firm, they can
duplicate the affects of corporate leverage on their own. Thus, if levered firms are priced too high, rational
investors will simply borrow on personal accounts to buy shares in unlevered firms.
A group of shareholders who, because of their personal leverage, seek to invest in
corporations that maintain a compatible degree of corporate leverage.
Measures of the relative contribution of stockholders and creditors, and of the firm's ability
to pay financing charges. Value of firm's debt to the total value of the firm.
Making transactions to adjust (rebalance) a firm's leverage ratio back to its target.
The beta of a leveraged required return; that is, the beta as adjusted for the degree of
leverage in the firm's capital structure.
The purchase of one business entity by another, largely using borrowed
funds. The borrowings are typically paid off through the future cash flow of
the purchased entity.
Leveraged buyout (LBO)
A transaction used for taking a public corporation private financed through the use
of debt funds: bank loans and bonds. Because of the large amount of debt relative to equity in the new
corporation, the bonds are typically rated below investment grade, properly referred to as high-yield bonds or
junk bonds. Investors can participate in an LBO through either the purchase of the debt (i.e., purchase of the
bonds or participation in the bank loan) or the purchase of equity through an LBO fund that specializes in
leveraged buyout (LBO)
Acquisition of the firm by a private group using substantial borrowed funds.
Stock in a firm that relies on financial leverage. Holders of leveraged equity face the
benefits and costs of using debt.
A lease arrangement under which the lessor borrows a large proportion of the funds needed
to purchase the asset and grants the lender a lien on the assets and a pledge of the lease payments to secure the
A portfolio that includes risky assets purchased with funds borrowed.
A portfolio that includes risky assets purchased with funds borrowed.
Leveraged required return
The required return on an investment when the investment is financed partially by debt.
Net benefit to leverage factor
A linear approximation of a factor, T*, that enables one to operationalize the
total impact of leverage on firm value in the capital market imperfections view of capital structure.
Fixed operating costs, so-called because they accentuate variations in profits.
A relatively small percent increase or decrease in
sales volume that causes a much larger percent increase or decrease in
profit because fixed expenses do not change with small changes in sales
volume. Sales volume changes have a lever effect on profit. This effect
should be called sales volume leverage, but in practice it is called operating
The short-term liabilities generated by the operating
(profit-making) activities of a business. Most businesses have three types
of operating liabilities: accounts payable from inventory purchases and
from incurring expenses, accrued expenses payable for unpaid expenses,
and income tax payable. These short-term liabilities of a business are
non-interest-bearing, although if not paid on time a business may be
assessed a late-payment penalty that is in the nature of an interest
the proportionate relationship between
a company’s variable and fixed costs
Degree to which costs are fixed.
The beta of an unleveraged required return (i.e. no debt) on an investment when the
investment is financed entirely by equity.
Unleveraged required return
The required return on an investment when the investment is financed entirely
by equity (i.e. no debt).
Adjusted present value (APV)
The net present value analysis of an asset if financed solely by equity
(present value of un-levered cash flows), plus the present value of any financing decisions (levered cash
flows). In other words, the various tax shields provided by the deductibility of interest and the benefits of
other investment tax credits are calculated separately. This analysis is often used for highly leveraged
transactions such as a leverage buy-out.
Bankruptcy cost view
The argument that expected indirect and direct bankruptcy costs offset the other
benefits from leverage so that the optimal amount of leverage is less than 100% debt finaning.
The annual sales volume level at which total contribution
margin equals total annual fixed expenses. The breakeven point is only a
point of reference, not the goal of a business, of course. It is computed by
dividing total fixed expenses by unit margin. The breakeven point is
quite useful in analyzing profit behavior and operating leverage. Also, it
gives manager a good point of reference for setting sales goals and
understanding the consequences of incurring fixed costs for a period.
Purchase of a controlling interest (or percent of shares) of a company's stock. A leveraged buy-out is
done with borrowed money.
The mix of the various types of debt and equity capital maintained by a firm. The more debt capital a firm has in its capital structure, the more highly leveraged the firm is considered to be.
Also called financial leverage ratios, these ratios compare debt to total capitalization
and thus reflect the extent to which a corporation is trading on its equity. Capitalization ratios can be
interpreted only in the context of the stability of industry and company earnings and cash flow.
The grouping of investors who have a preference that the firm follow a particular financing
policy, such as the amount of leverage it uses.
Indicator of financial leverage. Compares assets provided by creditors to assets provided
by shareholders. Determined by dividing long-term debt by common stockholder equity.
Indicator of financial leverage. Shows long-term debt as a proportion of the
capital available. Determined by dividing long-term debt by the sum of long-term debt, preferred stock and
common stockholder equity.
Management buyout (MBO)
leveraged buyout whereby the acquiring group is led by the firm's management.
management buyout (MBO)
Acquisition of the firm by its own management in a leveraged buyout.
Margin account (Stocks)
A leverageable account in which stocks can be purchased for a combination of
cash and a loan. The loan in the margin account is collateralized by the stock and, if the value of the stock
drops sufficiently, the owner will be asked to either put in more cash, or sell a portion of the stock. Margin
rules are federally regulated, but margin requirements and interest may vary among broker/dealers.
margin of safety
the excess of the budgeted or actual sales
of a company over its breakeven point; it can be calculated
in units or dollars or as a percentage; it is equal to
(1 - degree of operating leverage)
The inherent or fundamental risk of a firm, without regard to financial risk. The risk that is
created by operating leverage. Also called business risk.
A strategy using a leveraged portfolio in the underlying stock to create a synthetic put
option. The strategy's goal is to ensure that the value of the portfolio does not fall below a certain level.
return on assets (ROA)
Although there is no single uniform practice for
calculating this ratio, generally it equals operating profit (before interest
and income tax) for a year divided by the total assets that are used to
generate the profit. ROA is the key ratio to test whether a business is
earning enough on its assets to cover its cost of capital. ROA is used for
determining financial leverage gain (or loss).
Return on equity (ROE)
Indicator of profitability. Determined by dividing net income for the past 12
months by common stockholder equity (adjusted for stock splits). Result is shown as a percentage. Investors
use ROE as a measure of how a company is using its money. ROE may be decomposed into return on assets
(ROA) multiplied by financial leverage (total assets/total equity).
Sustainable growth rate
Maximum rate of growth a firm can sustain without increasing financial leverage.
sustainable growth rate
Steady rate at which a firm can grow without changing leverage; plowback ratio × return on equity.
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