In finance Finance is the science of funds management. The general areas of finance are business finance, personal finance, and public finance. Finance includes saving money and often includes lending money. The field of finance deals with the concepts of time, money, and risk and how they are interrelated. It also deals with how money is spent and budgeted, leverage (also known as gearing or levering) refers to the use of debt Debt is that which is owed; usually referencing assets owed, but the term can also cover moral obligations and other interactions not requiring money. In the case of assets, debt is a means of using future purchasing power in the present before a summation has been earned. Some companies and corporations use debt as a part of their overall to supplement investment.^[1] Companies usually leverage to increase returns to stock The stock or capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors. Stock is distinct from the property and the assets of a business which may fluctuate in, as this practice can maximize gains (and losses). The easy but high-risk increases in stock prices due to levering at banks in the United States ^ b. English is the de facto language of American government and the sole language spoken at home by 80% of Americans age five and older. Spanish is the second most commonly spoken language have been blamed for the unusually high rate of pay for top executives during the financial crisis of 2007–2010, since gains in stock are often rewarded regardless of method.^[2] Deleveraging is the action of reducing borrowings.^[1] In macroeconomics Macroeconomics (from Greek prefix "macr-" meaning "large" + "economics") is a branch of economics that deals with the performance, structure, behavior and decision-making of the entire economy, be that a national, regional, or the global economy. Along with microeconomics, macroeconomics is one of the two most general, a key measure of leverage is the debt to GDP ratio In economics, particularly macroeconomics, various debt-to-GDP ratios can be calculated. The most commonly used ratio is the Government debt divided by the Gross Domestic Product , which reflects the government's finances, while another common ratio is the total debt to GDP, which reflects the nation as a whole's finance.

Types of leverage

Financial leverage

Financial leverage (FL) takes the form of a loan A loan is a type of debt. Like all debt instruments, a loan entails the redistribution of financial assets over time, between the lender and the borrower or other borrowings Debt is that which is owed; usually referencing assets owed, but the term can also cover moral obligations and other interactions not requiring money. In the case of assets, debt is a means of using future purchasing power in the present before a summation has been earned. Some companies and corporations use debt as a part of their overall (debt), the proceeds of which are (re)invested with the intent to earn a greater rate of return than the cost of interest. If the firm's rate of return on assets This number tells you what the company can do with what it has, i.e. how many dollars of earnings they derive from each dollar of assets they control. It's a useful number for comparing competing companies in the same industry. The number will vary widely across different industries. Return on assets gives an indication of the capital intensity of (ROA) is higher than the rate of interest Interest is a fee paid on borrowed assets. It is the price paid for the use of borrowed money, or, money earned by deposited funds. Assets that are sometimes lent with interest include money, shares, consumer goods through hire purchase, major assets such as aircraft, and even entire factories in finance lease arrangements. The interest is on the loan, then its return on equity Return on Equity (requity) measures the rate of return on the ownership interest (shareholders' equity) of the common stock owners. It measures a firm's efficiency at generating profits from every unit of shareholders' equity (also known as net assets or assets minus liabilities). ROE shows how well a company uses investment funds to generate (ROE) will be higher than if it did not borrow because assets = equity + debt (see accounting equation The 'basic accounting equation' is the foundation for the double-entry bookkeeping system. It shows how assets were financed: either by borrowing money from someone or by paying your own money (ownership equity)). On the other hand, if the firm's ROA is lower than the interest rate, then its ROE will be lower than if it did not borrow. Leverage allows greater potential returns to the investor that otherwise would have been unavailable but the potential for loss is also greater because if the investment becomes worthless, the loan principal and all accrued interest on the loan still need to be repaid.

Margin buying In finance, a margin is collateral that the holder of a financial instrument has to deposit to cover some or all of the credit risk of his counterparty . This risk can arise if the holder has done any of the following: is a common way of utilizing the concept of leverage in investing Investment is the commitment of money or capital to purchase financial instruments or other assets in order to gain profitable returns in form of interest, income, or appreciation of the value of the instrument. It is related to saving or deferring consumption. Investment is involved in many areas of the economy, such as business management and. An unlevered firm can be seen as an all-equity firm, whereas a levered firm is made up of ownership equity In accounting and finance, equity is the residual claim or interest of the most junior class of investors in assets, after all liabilities are paid. If valuations placed on assets do not exceed liabilities, negative equity exists. In an accounting context, Shareholders' equity represents the remaining interest in assets of a company, spread among and debt Debt is that which is owed; usually referencing assets owed, but the term can also cover moral obligations and other interactions not requiring money. In the case of assets, debt is a means of using future purchasing power in the present before a summation has been earned. Some companies and corporations use debt as a part of their overall. A firm's debt to equity ratio The debt-to-equity ratio is a financial ratio indicating the relative proportion of shareholders' equity and debt used to finance a company's assets. Closely related to leveraging, the ratio is also known as Risk, Gearing or Leverage. The two components are often taken from the firm's balance sheet or statement of financial position (so-called is therefore an indication of its leverage. This debt to equity ratio's influence on the value of a firm is described in the Modigliani-Miller theorem The Modigliani-Miller theorem forms the basis for modern thinking on capital structure. The basic theorem states that, under a certain market price process (the classical random walk), in the absence of taxes, bankruptcy costs, and asymmetric information, and in an efficient market, the value of a firm is unaffected by how that firm is financed. As is true of operating leverage The operating leverage is a measure of how revenue growth translates into growth in operating income. It is a measure of leverage, and of how risky a company's operating income is, the degree of financial leverage measures the effect of a change in one variable on another variable. Degree of financial leverage (DFL) may be defined as the percentage change in earnings (earnings per share In the United States, the Financial Accounting Standards Board requires companies' income statements to report EPS for each of the major categories of the income statement: continuing operations, discontinued operations, extraordinary items, and net income) that occurs as a result of a percentage change in earnings before interest and taxes.

Measures of financial leverage

Debt-to-equity

Debt to equity is generally measured as the firm's total liabilities divided by shareholders' equity In accounting and finance, equity is the residual claim or interest of the most junior class of investors in assets, after all liabilities are paid. If valuations placed on assets do not exceed liabilities, negative equity exists. In an accounting context, Shareholders' equity represents the remaining interest in assets of a company, spread among. In the following, D = liabilities, E = equity, A = total assets, EBIT = Earnings before interest and taxes In accounting and finance, earnings before interest and taxes or operating income is a measure of a firm's profitability that excludes interest and income tax expenses and Interest = Interest payment:

Debt-to-equity ratio =

Debt-to-value ratio = = Debt-to-assets^[3]

Interest coverage ratio =

Degree Of Financial Leverage (DFL)

Financial Leverage affects the EPS In the United States, the Financial Accounting Standards Board requires companies' income statements to report EPS for each of the major categories of the income statement: continuing operations, discontinued operations, extraordinary items, and net income (Earnings per Share) of the firm. Financial Leverage acts as a double-edged sword. If the economic conditions are favorable and EBIT In accounting and finance, earnings before interest and taxes or operating income is a measure of a firm's profitability that excludes interest and income tax expenses is increasing, a higher financial leverage has a positive impact on the EPS. The DFL captures this relationship between EBIT and EPS. DFL is defined as the percentage change in EPS for a given percentage change in EBIT.

Symbolically,

Financial leverage = 1/Equity Ratio

For different applications of leverage, analysts may include or exclude certain items, such as non-tangible balance sheet items, non-financial liabilities, and similar items, or may adjust the carrying value In accounting, book value or carrying value is the value of an asset according to its balance sheet account balance. For assets, the value is based on the original cost of the asset less any depreciation, amortization or impairment costs made against the asset. Traditionally, a company's book value is its total assets minus intangible assets and of other items. It is not uncommon to use only financial liabilities (long-term and short-term borrowings), thereby excluding, for example, accounts payable.

Gearing and Du Pont Analysis

Use of the Du Pont Identity requires that leverage be measured in terms of total assets divided by shareholders' equity, and this is sometimes referred to as gearing or simply leverage:

Leverage (gearing) = A / E

The two measures are related. Since the terms used are the same throughout, debt-to-equity is equal to gearing times debt over assets: D / E = (A / E) * (D / A)

Operating leverage

Operating leverage The operating leverage is a measure of how revenue growth translates into growth in operating income. It is a measure of leverage, and of how risky a company's operating income is reflects the extent to which fixed assets and associated fixed costs are utilized in the business. Degree of operating leverage The operating leverage is a measure of how revenue growth translates into growth in operating income. It is a measure of leverage, and of how risky a company's operating income is (DOL) may be defined as the percentage of levering.

Combined stand-alone leverage

If both operating and financial leverage allow us to magnify our returns, then we will get maximum leverage through their combined use in the form of combined leverage. Operating leverage affects primarily the asset and operating expense structure of the firm, while financial leverage affects the debt-equity mix. From an income statement viewpoint, operating leverage determines return from operations, while financial leverage determines how the “fruits of labour” will be divided between debt holders (in the form of payments of interest and principal on the debt) and stockholders (in the form of dividends). Degree of combined leverage (DTL) uses the entire income statement and shows the impact of a change in sales or volume on bottom-line earnings per share. Degree of operating leverage and degree of financial leverage are, in effect, being combined.

Correlation leverage

Correlation leverage is a third concept that captures the degree to which the variability in the firm's value is correlated In statistics, correlation and dependence are any of a broad class of statistical relationships between two or more random variables or observed data values with the variability of the universe of all risky assets.

Derivatives

Derivatives A derivative, in non-financial-expert terms, is an agreement or contract that is not based on a real, or true, exchange, i.e.: There is nothing tangible like money, or a product, that is being exchanged. For example, a person goes to the grocery store, exchanges a currency for a commodity (say, an apple). The exchange is complete, both parties allow leverage without borrowing explicitly, though the "effect" of borrowing is implicit in the cost of the derivative.

• Buying a futures contract In finance, a futures contract is a standardized contract between two parties to buy or sell a specified asset of standardized quantity and quality at a specified future date at a price agreed today . The contracts are traded on a futures exchange. Futures contracts are not "direct" securities like stocks, bonds, rights or warrants. They magnifies your exposure with little money down.
• Options In finance, an option is a type of financial instrument classed as derivatives because they derive their value from an underlying asset. An option gives its holder the right, but not the obligation, to buy or to sell some asset on or before the option's expiration at an agreed price, the strike price do the same. The purchase of a call option The buyer of a call option wants the price of the underlying instrument to rise in the future; the seller either expects that it will not, or is willing to give up some of the upside from a price rise in return for the premium (paid immediately) and retaining the opportunity to make a gain up to the strike price (see below for examples) on a security gives the buyer the right to purchase the underlying security at a given price in the future. If the price of the underlying security rises, the value of the call option will rise at a rate much greater than the value of the underlying security. However if the rate of the call option falls or does not rise, the call option may be worthless, involving a much greater loss than if the same money had been invested in the underlying instrument. Generally speaking, a put option allows the holder (owner), the investor, to achieve inverted-leverage and/or inverted enhancement--- sometimes called inverse enhancement and/or inverse leverage.
• Structured products that exist as either closed-ended funds, or public companies, or income trusts are responding to the public's demand for yield by levering.

Risk and overleverage

Employing leverage amplifies the potential gain from an investment or project, but also increases the potential loss. Interest and principal payments (usually certain ex-ante) may be higher than the investment returns (which are uncertain ex-ante).

This increased risk Risk concerns the deviation of one or more results of one or more future events from their expected value. Technically, the value of those results may be positive or negative. However, general usage tends to focus only on potential harm that may arise from a future event, which may accrue either from incurring a cost or by failing to attain some may still lead to the optimal outcome for the entity or person making the investment. In fact, precisely managing risk utilizing strategies including leverage and security purchases, is the subject of a discipline known as financial engineering The financial engineering methodologies usually apply social theories, engineering methodologies and quantitative methods to finance. It is normally used in the securities, banking, and financial management and consulting industries, or as quantitative analysts in corporate treasury and finance departments of general manufacturing and service.

There are economic periods when optimism The Oxford English Dictionary defines optimism as having "hopefulness and confidence about the future or successful outcome of something; a tendency to take a favourable or hopeful view." The word is originally derived from the Latin optimum, meaning "best." Being optimistic, in the typical sense of the world, ultimately means incites to a widespread and excessive use of leverage, what is called overleverage. One of its forms, associated to the subprime crisis, was the practice of financing homes with no or little down payment, playing on the hope that the price of the assets (the property in this case) will rise. Another form involved the five largest U.S. investment banks, which borrowed funds to invest in mortgage-backed securities A mortgage-backed security is an asset-backed security or debt obligation that represents a claim on the cash flows from mortgage loans, most commonly on residential property, increasing their leverage between 2003-2007 (see diagram). During September 2008, the five largest firms either went bankrupt (Lehman Brothers Lehman Brothers Holdings Inc. (pronounced /ˈliːmən/) was a global financial services firm which, until declaring bankruptcy in 2008, participated in business in investment banking, equity and fixed-income sales, research and trading, investment management, private equity, and private banking. It was a primary dealer in the U.S. Treasury), were bought out by other banks (Merrill Lynch Bank of America Merrill Lynch is the investment banking and wealth management division of Bank of America. With over 20,000 brokers and $2.5 trillion in client assets it is the world's largest brokerage. Formerly known as Merrill Lynch & Co., Inc., prior to 2009 the firm was publicly owned and traded on the New York Stock Exchange under the and Bear Stearns The Bear Stearns Companies, Inc. based in New York City, was a global investment bank and securities trading and brokerage, until its collapse and fire sale to JPMorgan Chase in 2008. The main business areas, based on 2006 net revenue distributions, were capital markets (equities, fixed income, investment banking; just under 80%), wealth) or changed to commercial bank holding companies, subjecting themselves to leverage restrictions (Morgan Stanley Morgan Stanley is a global financial services firm headquartered in New York City, New York, United States serves a diversified group of corporations, governments, financial institutions, and individuals. Morgan Stanley also operates in 36 countries around the world, with over 600 offices and a workforce of over 60,000. The company reports US$779 and Goldman Sachs The Goldman Sachs Group, Inc. is a global investment banking and securities firm which engages in investment banking, securities, investment management, and other financial services primarily with institutional clients. Goldman Sachs was founded in 1869 and is headquartered at 200 West Street in the Lower Manhattan area of New York City, with).

Negative gearing

Negative gearing is a form of financial leverage where an investor The term has taken on a specific meaning in finance to describe the particular types of people and companies that regularly purchase equity or debt securities for financial gain in exchange for funding an expanding company. Less frequently, the term is applied to parties who purchase real estate, currency, commodity derivatives, personal property borrows money to buy an asset In financial accounting, assets are economic resources. Anything tangible or intangible that is capable of being owned or controlled to produce value and that is held to have positive economic value is considered an asset. Simplistically stated, assets represent ownership of value that can be converted into cash . The balance sheet of a firm, but the income generated by that asset does not cover the interest Interest is a fee paid on borrowed assets. It is the price paid for the use of borrowed money, or, money earned by deposited funds. Assets that are sometimes lent with interest include money, shares, consumer goods through hire purchase, major assets such as aircraft, and even entire factories in finance lease arrangements. The interest is on the loan. A negative gearing strategy can only make a profit if the asset rises in value and creates enough future capital gains to cover the shortfall between the income and interest that the investor suffers. The investor must also be able to fund that shortfall until the asset is sold. The tax treatment of interest expenses and future gain will also affect the investor's final return.

Variations

Levering is often referred to as leveraging. Leveraging is a slang term and misuse of the English language. 'Leverage' is a noun and can not be conjugated as a verb.

Its use is becoming more wide spread http://dictionary.reference.com/browse/leverage, though there is resistance [1]

Mathematical Example

[4] Calculate equity return given:

5% Projected Return on Investment
4% Cost of Debt
8:1 Leverage Debt:Equity

LONG-FORM MATH

Investment (8+1) * 5% = 45
less Interest (8) * 4% = 32
equals Equity 1 * 13%= 13

SHORT-FORM GENERIC CALCULATION

Interest Rate Differential (5-4) = 1%
Debt to Equity Multiple (8/1) = 8
Multiply Line1 * Line2 (1*8) = 8%
Add Investment Return + 5%
Equals Total Return (8+5) = 13%

See also

• Coupon leverage
• Debt Debt is that which is owed; usually referencing assets owed, but the term can also cover moral obligations and other interactions not requiring money. In the case of assets, debt is a means of using future purchasing power in the present before a summation has been earned. Some companies and corporations use debt as a part of their overall
• Debt to GDP ratio In economics, particularly macroeconomics, various debt-to-GDP ratios can be calculated. The most commonly used ratio is the Government debt divided by the Gross Domestic Product , which reflects the government's finances, while another common ratio is the total debt to GDP, which reflects the nation as a whole's finance
• Leveraged buyout A leveraged buyout (or LBO, or highly-leveraged transaction , or "bootstrap" transaction) occurs when an investor, typically financial sponsor, acquires a controlling interest in a company's equity and where a significant percentage of the purchase price is financed through leverage (borrowing). The assets of the acquired company are
• Margin (finance) In finance, a margin is collateral that the holder of a financial instrument has to deposit to cover some or all of the credit risk of his counterparty . This risk can arise if the holder has done any of the following:
• Sticky bonuses

References

1. ^ ^{a b} BBC The British Broadcasting Corporation is the largest broadcasting organisation in the world. Its global headquarters are located in London and its main responsibility is to provide public service broadcasting in the United Kingdom, Channel Islands and Isle of Man. The BBC is an autonomous public service broadcaster that operates under a Royal. The layman's finance crisis glossary. Retrieved 2008-10-23
2. ^ Peston, Robert. Why Bankers Aren't Worth It.. 3 July 2009 BBC.
3. ^ As A = D + E, by the accounting equation.
4. ^ Math for calculating leverage effects

External links

• An Introduction to Leverage in Trading, at InformedTrades.com
• Corporate Leverage - Revisited

Categories: Basic financial concepts | Financial ratios | Debt

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