In financial terms, leverage is defined as the use of a particular asset in order to increase the available funds of another. With the leverage, the more one has, the greater the ability to increase one’s income. What is leveraged, then, is money or a company’s stock, as the case may be.
Leverage comes in many forms. For example, when you lend someone money or purchase a stock, you are effectively loaning them money or signing on the dotted line. The lender has the leverage and is able to increase the value of his loan, while at the same time decreasing the rate at which he has to pay interest. This decreased rate of interest lowers the cost of borrowing and allows the lender to increase the value of the loan.
Companies have used leverage in order to obtain larger profits. For example, a large corporation that produces a specific product can leverage its production to allow it to produce more products at a lower cost. In the process of leveraging its production, the corporation obtains increased value for its stock in the stock market. Essentially, because the company is able to produce more at a lower cost, the stock price of the company goes up. This increases the net worth of the company and allows it to reap profits.
Leverage also refers to the ability of a borrower to increase the amount he is willing to lend a company. For example, if a borrower wants to increase his funding of a business by 100%, he would use this money to purchase additional shares of stock. As part of the loan, the borrower is able to increase the amount of equity he has in the business. Leverage thus allows the business owner to increase the potential return on his investment.
On the other hand, when a company is leveraged, the owner or manager actually loose some control over the business. Because of this, when the value of the business is reduced, the owners or managers are typically not very happy. However, if they are not happy with the performance of their company, they have the option of selling their stock. Usually, the selling of the stock results in reduced liquidity (however, it may also result in an increase in value).
When there is leverage, however, something tends to equal a value – for example, the stock will be bought at a lower price and sold back at a higher price. Therefore, the owner or manager of the company has increased the value of his equity. The concept of leverage relates to how things work in the market. If you borrow money and pay it back later, the interest you pay will also increase with time.
However, because the profits that result form the leveraged stock transaction are reduced, the net worth of the company is decreased. This means that during the period in which the value of the stock increases, the owner or manager of the business is reduced in cash. Therefore, while the increased value provides a positive cash flow, the reduction of cash flow results in what is known as the liquidity effect. In other words, as the number of shares outstanding decreases, so too does the value of the business. Because of this, stock prices are sensitive to changes in either the availability of capital or in the profitability of a particular business.
So, it’s not enough to just look at the actual stock price and consider it to be leverage. It must be determined whether or not the company has leverage, and what impact that has on the value of the stock. Likewise, the owner or manager of the business must determine if the leveraged stock transaction is actually appropriate for his needs. For example, if the value of the shares is expected to go up, then buying them now makes sense. On the other hand, if the value goes down, it would make more sense to hold onto the stock until the price recovers.