Here are some notes on leverage/gearing in detail:
- Leverage or gearing is the use of borrowed funds to increase the potential return on an investment. It is a financial tool that can be used to amplify gains, but it can also magnify losses.
- There are two main types of leverage: financial leverage and operating leverage. Financial leverage occurs when a company uses debt to finance its operations. Operating leverage occurs when a company’s fixed costs are high relative to its variable costs.
- The amount of leverage used by a company is measured by its debt-to-equity ratio. The debt-to-equity ratio is the ratio of a company’s debt to its equity. A higher debt-to-equity ratio indicates that a company is using more leverage.
- Leverage can be a powerful tool for increasing returns, but it can also be risky. If the value of an investment falls, the losses will be magnified if leverage is used. This is because the investor will have to repay the borrowed funds even if the investment loses value.
- The use of leverage should be carefully considered by investors. The amount of leverage that is appropriate for an investor will depend on their risk tolerance and investment objectives.
Here are some of the benefits of using leverage:
- Increased potential returns: Leverage can increase the potential returns on an investment. This is because the investor can use borrowed funds to amplify their investment.
- Improved financial flexibility: Leverage can improve the financial flexibility of a company. This is because it can give the company the ability to take on more risk and grow more quickly.
Here are some of the risks of using leverage:
- Increased financial risk: Leverage can increase the financial risk of an investment. This is because the investor is exposed to more risk if the value of the investment falls.
- Reduced financial flexibility: Leverage can reduce the financial flexibility of a company. This is because it can make it more difficult for the company to raise additional capital if needed.