Financial Leverage And Return On Equity - What is Leverage?

Article by Mike Singh

 

You've probably heard the term before, leverage, but what exactly does it mean? Another term is gearing. So when you use this, you are also doing what can be called gearing. In essence means using the resources that are available to magnify the positive or negative aspect in the final product or result.

               
Usually when you do this type of dealing in business or finance, it is similar or synonymous with borrowing. This greatly involves ROA (return on assets) and ROE (return on equity). The main point is to make ROE higher than the ROA. If it is not, leverage or borrowing can be used.

Some of the basics of how this leverage works include reinvesting a previous loan. When you reinvest the loan you are borrowing or using leverage to get a better ROE on your loan. This type of leverage can involve a lot of risk, but to many it is very much worth it. This is because leverage can give you better returns and greater potential as well.

There is also a theory called the Modigliani-Miller theorem that involves leverage. This theory has to do with a company's equity versus their debt. For example, one that has none actually is known as an all equity firm. While one that has leverage is one that has both equity and debt. The value of the ratio between the two is how much leverage the company has available to them.       

 There is yet another form of leverage that involves the use of options. Usually something called a call option is purchased. This gives the investor an advantage because they are able to purchase these options at what is called the underlying security at any time. The value of the actual security will rise more sharply then the underlying one. This gives the investor a lot of ability to earn more money if value increases. There is of course a risk in this as well, but the leverage that can be gained from it is invaluable.

In general when you use leverage, you will be taking some risks. In the end, a lot of people will find that the benefits of using this technique far outweigh these risks. This is because a lot can be gained if leverage is used in the right time and in the right place. Make sure you carefully weigh the pros and cons before you decide to use leverage for yourself. But if you should decide to do so, you may be glad you did.