How you transform your average transaction into a fantastic transaction.
Truth is, leverage can turn an average transaction into something really great. This article explains what leverage is and why it is such a powerful tool.
What is leverage?
Leverage is a tool in which you use some kind of debt in order to increase your returns. The interesting thing is that with leverage it is possible to increase the return of an investment beyond the return that you would achieve without using leverage. The process of leveraging is very simple. Say you want to buy an asset for $ 1,000. There are basically two ways how you could do that:
- You buy the asset all equity. This is how we pay for almost everything that we buy in our daily lives (at least that is what we should do). You go into the supermarket, buy milk, bread and butter, go to the cashier and pay the amount stated with your cash. However, there is also another way how you could pay…
- You buy the asset(s) not only with equity, but also with debt that you borrow from a lender. Let’s say you buy the product worth $ 1,000 with $ 500 in equity and the rest with $ 500 in debt.
What is the difference?
Well, in the first case you bought the asset with equity. After paying the purchase price you are done. Nothing more, nothing less. The difference with the second case is that you need less equity (only $ 500 instead of $ 1.000) but you also need some debt ($ 500). Therefore, you need someone who lends you the money. Lenders are often either friends and family, or a bank. The important thing here is that you usually do not get your debt for free. The bank charges some interest on the amount lent to you.
Here is an easy to understand example what leverage is all about
Purchase price of the asset: $ 1,000
Yearly cash flow generated by the asset: $ 100
Situation 1: Asset is bought all equity
At the beginning we have an equity cash outflow of $ 1.000 and get $ 100 back at the end of the year. Because we do not owe anyone any money the $ 100 belong to us. Our return on equity is thus: $ 100 / $ 1.000 = 10%
Situation 2: Asset is bought with $ 500 in equity and $ 500 in debt. The interest rate is 3.0% p.a.
At the beginning our equity cash outflow is $ 500. Our yearly cash flow generated by the asset of $ 100 is reduced by the interest payment of $ 15 (= 3.0% x $ 500) leaving us with a cash flow of $ 85. Our return on equity is now: $ 85 / $ 500 = 17%
With the use of leverage (taking on debt) we could substantially increase our return on equity from 10% to 17%. Awesome! But stay with me, it gets even better…
Situation 3: Asset is bought with $ 100 in equity and $ 900 in debt. The interest rate remains at 3.0% p.a.
What happens now with the return on equity once we increased our debt portion?
Well let’s see…
First, our equity cash outflow is $ 100. The yearly cash flow generated by the asset of $ 100 is reduced by the interest payment of $ 27 (= 3.0% x $ 900) leaving us with a cash flow of $ 73.
Our return on equity is now: $ 73 / $ 100 = 73%
Wow. This now became a really great deal!
Equity used ($)
|Equity used (%)||Debt used (%)||Return on equity|
As you can see, the less equity is used, the higher the return on equity gets.
But is that the reality?
To be honest, the reality often does not work as easy as the example. Why is that the case? There are actually two problems coming along with the use of leverage:
- The more debt you use, the more expensive the debt becomes
- Higher leverage means higher risk
1.) Put yourself in the shoes of a banker who is in discussions with a client that wants to buy an asset of $ 1.000. How much would you lend him? Bankers are all about managing risks. You might lend him $ 100 because you might be sure that in the unlikely case that you have to sell the asset again you will recover your outstanding loan of $ 100 by the selling proceeds of the asset. So a loan of $ 100 seems to be less risky. You will charge the client an interest rate of e.g. 1.0% p.a.
What about lending him $ 900? Now the debt portion is very high. You cannot be sure that the selling proceeds of the asset will recover the total outstanding debt. This seems to be very risky. For taking on so much risk you charge the client a higher interest rate of e.g. 5.0% p.a.
In reality a bank will not lend you any amount of debt. There is certainly a “sweet spot” where you get as much debt for a reasonable price. This is the spot that you should find in order to maximize your return on equity.
2.) In our example we saw that more leverage means more return on equity. What happens if our investment does not pay out, if it fails and does not produce any yearly cash flows at all? Well in Situation 1 our return on equity would be $ 0 / $ 1.000 = 0%.
In Situation 2 the return on equity would be $ -15 / $ 500 = -3%. We actually run a negative return on equity. In other words, we not only lost our initial equity amount of $ 500, we even have to pay more ($ 15 in interest).
In Situation 3 the return on equity would be $ -27 / $ 100 = -27%. Our balance shows us that we not only lost our total equity of $ 100 but also have to pay $ 27 in interest expense.
Long story short: The leverage effect works in both directions. It can substantially increase our return on equity if it is a good investment. However leverage can also work against us if our investment fails.
For more information on the leverage effect I can recommend the Investopedia page on “Leverage”.