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Leverage capital is when a business or institution uses its own funds plus borrowed funds for investment. The ratio between the borrowed funds and the investor’s own funds is the leverage ratio. Banks have higher leverage ratios than corporations, but both must consider the risk level of their investments. The potential returns and losses are magnified with leveraged capital.
A business or institution can use its own funds plus borrowed funds for investment. This is also known as leverage capital. As long as the capital (own assets), plus the borrowed funds are invested at a higher rate of return than the interest on the borrowed funds, the company or institution earns money. The ratio between the borrowed funds and the investor’s own funds is the leverage ratio.
A simple example of using leveraged capital is a bank business. A bank acts as a financial intermediary. Bank depositors and shareholders contribute the capital. The bank lends the capital to qualified borrowers. As long as the interest rate paid by borrowers exceeds the interest rate the bank has promised to depositors, then the bank makes a profit.
Commercially insured banks have average leverage ratios of 15 to one. Their leverage ratios are typically much higher than those of corporations because banks are in business to provide leverage capital for others. Although they are required to have certain reserves, banks often make money by lending money at interest. Banks protect themselves by tightening their lending practices to lessen the chance of loan defaults.
Financial leverage is also known as equity trading. The ratio of funded debt to equity (leverage ratio) is an important statistic in determining the health of a company. Higher leverage ratios make it important to understand the risk level of the company’s investments. If a business uses leveraged capital, the potential returns and losses are magnified.
A company will leverage its equity because it gives the company the potential for a higher return on its funds. Leverage ratios for corporations are much lower than for banks. If a company has $200,000 US Dollars (USD) in capital and borrows $400,000 USD, the leverage ratio is two to one. If the company invests $600,000 USD, then the return on investment must be a higher percentage than what the company owes the bank. A five percent bank loan would require a return on investment of more than five percent to be profitable for the company.
The net relationship between loan interest and investment return is augmented by the leverage ratio. If a corporation borrows funds at five percent and earns a yield of ten percent, the interest due would be $20,000. The total return on your investment would be $60,000 USD. Once the loan is paid off, the corporation would have a $40,000 increase in equity.
When the yield is less than the interest rate on the loan, the use of leveraged capital can decrease the total equity a corporation has. If the return on the previous investment had only been four percent, then the total return would have been $24,000 USD. The increase in equity is minimal. With a three percent return, the corporation begins to lose capital. The use of leverage capital must be weighed against all risk factors. Corporations exercise caution and due diligence when choosing investments for leveraged funds.
Smart Asset.
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