Leverage, deleveraging

Leverage is the use of debt to finance a firm’s assets. The higher a firm’s debt relative to equity, the higher its leverage.

Deleveraging is the opposite of leveraging, and involves a company’s attempt to decrease its leverage. This can be achieved by immediately paying off existing debt.

Companies can finance themselves through debt or equity. Most companies use at least some debt to finance their operations. This increases their level of leverage, because they can invest in new assets and projects without having to increase their equity.

Leverage can enhance returns to equity holders. If a company is formed with CHF 10 million from shareholders and it borrows CHF 30 million, it now has CHF 40 million to invest in profitable projects and increase value for shareholders. If the investment is profitable, the shareholders stand to gain fully from the upside, even though they have only contributed 25% of the capital required to achieve this return. Thus leverage can initiate growth.

The danger with leverage is that if these projects fail and losses are incurred, the loss is much greater than it would have been if the investment had not been leveraged. If the business makes bad investment decisions and is unable to generate sufficient cash-flow to pay interest and repay the principal on the debt, this can increase the risk of default. If a company becomes insolvent or bankrupt, shareholders are the last to be paid after the government and debtholders. Therefore too much leverage substantially increases the riskiness and can destroy shareholder value if investments turn bad.

Leverage magnifies both gains and losses.