Leverage

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Analyzing the Balance Sheet to Determine Leverage

A balance sheet analysis allows investors to examine the debt and equity on the books of various companies and invest in firms that finance their operations with debt. An investor can determine how companies are using their capital and how much of it is borrowed by analyzing ratios such as the return on equity (ROE), debt-to-equity ratio, and return on capital employed (ROCE). In order to interpret these ratios properly, it is important to be aware that there are different types of leverage, such as operating, financial, and combined leverage.

In fundamental analysis, the degree of operating leverage is considered. The degree of operating leverage is calculated by dividing the percentage change in a company's earnings per share (EPS) by the percentage change in earnings before interest and taxes (EBIT) over a given period. A company's operating leverage can be calculated by dividing its EBIT by EBIT minus interest expense. In general, higher operating leverage ratios indicate a greater degree of volatility in a company's earnings per share (EPS).

A company's equity multiple can also be used to measure leverage. To calculate it, the company's total assets are divided by its total equity. When a company has total assets of CHF 1,000,000 and equity of CHF 500,000, its division yields a value of 2. This is referred to as the equity multiple. The figures indicate that the total assets are twice as high as the equity - or vice versa, that half of the total assets are financed by equity. Therefore, higher equity multipliers indicate greater financial debt.

Leverage vs. Margin

A margin loan is a loan provided by a brokerage institution to make investments in equity instruments and other similar instruments. The term margin refers to the amount of money required to open a position. Leverage refers to borrowing money to generate higher returns and account for shares in the business.

A margin can also be considered a form of leverage that uses existing cash or securities positions as collateral to increase the business's purchasing power. Thus, margin is a tool for borrowing money from a lender at a fixed interest rate in order to acquire positions, securities, and futures contracts at a profit. While margin and leverage are not exactly the same, margin can be used to create leverage in order to increase your buying power.

In this way, margins create leverage by increasing your purchasing power by the margin amount. For example, if you are purchasing securities worth CHF 1000 and must provide CHF 100 as collateral, your margin would be 1:10 (and your leverage would be ten times higher).

Leverage - Examples

Example 1 - Companies

Suppose that company X was founded with an investment of CHF 2 million from investors and that the company's equity is CHF 1 million. If the company takes out an additional loan of CHF 2 million, it will have a total of CHF 3 million to invest in operations (1 million equity plus 2 million debt). By doing so, company X is able to increase the value of its shareholders. The company might, for example, invest in a new production facility that would enable it to produce more and increase profits. There is an advantage when the additional profit exceeds the cost of the borrowed capital (interest).

Example 2 - Private Investors

An investor wants to invest CHF 5000 in shares. Assume that the shares produce a profit of CHF 500, which is a 10% return. Divide the profit by the equity and multiply by 100 to determine the return on equity. Consider the case where the investor now uses debt capital in addition to equity capital. In this case, the investor invests CHF 5000 in equity and borrows another CHF 5000 from the bank (debt capital), which he also invests. The investor must pay 5% interest on the borrowed capital. Since twice as much was invested, the profit initially doubles. So, the investor receives CHF 1000 in return, but his profit is reduced by the interest he must pay back to the bank. In this case, the investor pays CHF 250 to the bank. However, since the investment profit (CHF 500) exceeds the interest (CHF 250) in this example, the investor gains additional profit through the use of borrowed funds. Thus, the rate of interest (5%) is lower than the rate of return (10%). If, however, there is less return than is paid in interest, then the leverage effect may have a negative effect.

Advantages and Disadvantages of Leverage

Like any other financial product, leverage has its advantages and disadvantages. Leverage is a multifaceted financial product that is inherently complex and can increase profits as well as losses when used by either a company or an individual investor. While the theory sounds great, in practice leverage can be both profitable and detrimental, since leverage increases both profits and losses. Thus, leverage should only be used by experienced investors or with the assistance of a qualified investment advisor.

In summary, there are the following advantages and disadvantages:

Advantages

It is possible for companies to make small investments through leveraged investments. Leveraged investment allows these companies and businesses to acquire more assets and funds for their organization. Let us assume that the value of the assets has increased and that the terms are favorable. Borrowers have a great advantage in this case as they can earn higher returns on their investments, which allows them to remain within their profit margins.

Disadvantages

Using debt carries the risk that companies may suffer a loss if the value of their assets declines and is less than the interest they must pay. There is an increased risk of financial loss in certain industries, such as construction, oil production, and automobile manufacturing, which can result in very large losses if the value of their assets declines.

Leverage in investments may be harmful to companies if it is not used properly. Particularly affected are companies with less predictable revenues and lower profitability. For this reason, many first-time investors are advised not to use leverage until they have gained sufficient experience to avoid a large loss.

As a result, leverage is a two-edged sword: a prominent example can be found in the case of ABB. The company had optimized its capital structure to such an extent that rumors of liquidity bottlenecks persisted around 2002. As a result, equity was low and debt was high - accounting for more than 70% of total capital. Consequently, ABB had difficulties raising long-term debt and had to pay high interest rates. In order to turn the tide, ABB successfully reduced its debt and increased the proportion of debt with longer maturities. However, ABB could have been insolvent if it did not restructure the debt in time.

Likewise, private investors should be careful when using leverage, i.e. when the ratio between the loan and collateral value becomes excessive. This may result in the borrower being required to deposit additional collateral, to repay a portion of the loan, or even in the transfer of ownership of the asset - which was deposited as collateral - to the lender. In other words, the collateral deposited can also be lost. There have already been instances where borrowers have accumulated more debt than their assets and have been unable to repay them. However, these are extreme examples and also a sign that lenders did not have their risks under control and had issued too much credit to individual borrowers.

Whether you are an investor or a company, it is extremely important to take into account the above advantages and disadvantages and to weigh all possible risks before making a leveraged investment.