What It Is:

The basic idea behind leverage is to magnify the profit potential from an investment opportunity by using borrowed money. It is a concept with uses in corporate expansions, mergers & acquisitions, trading & portfolio management, and other areas of the financial world.

How It Works/Example:

Let's assume Company XYZ has invented a new product that will revolutionize the widget market, but it needs to build a new factory. If Company XYZ's funds for constructing the factory were limited to its cash on hand, say $200,000, it certainly could not build the kind of factory it needs to capitalize on this tremendous opportunity.

Company XYZ has two options: borrow money or issue new common shares. Existing shareholders have voted down the second option because they want the potential profits for themselves. With some dP/E9, however, Company XYZ could build the factory and take advantage of the profit potential, essentially magnifying shareholders current equity.

But leveraging it is not without risk, it actually increases risk. It requires a commitment to keep up with the principal and interest payments, and this ability can depend on conditions in the capital markets such as bond investors' perception of risk or sudden interest rate changes. Additionally, the company may have to pledge its assets as collateral.

Mergers & Acquisitions
Another popular use of leverage is a mechanism for merger activity, especially leveraged buyouts (LBOs). An LBO is a method of acquiring a company with money that is nearly all borrowed.Its purpose is to make a large acquisition without having to commit a lot of equity, and usually involves securing the loan with the target company's assets.

In some cases, the acquirer issues bonds in the open market to raise the capital for the acquisition. Because the combined entity is often highly leveraged, the bonds are usually not investment grade and considered "junk bonds." In other cases, the capital comes from one or more financial institutions. Either way, the acquirer must be sure the combined entities will generate enough cash to make the principal and interest payments.

Trading Activity and Portfolio Management
Trading on margin is another use of leverage. It involves borrowing money for a specific time period for a specific interest rate. Investors trading on margin usually intend to make more than enough on their trade or investment to cover the cost of borrowing the additional capital.

Trading on margin can be a risky endeavor because the borrower is amplifying their profits and losses. If the investment works out, the investor might turn a $1,000 trade into a $2,000 trade. But if it doesn't work out, a $1,000 loss turns into a $2,000 loss.

Why It Matters:

Too much debt can be a very, very bad thing, but a little can go a long way. No matter what its use, leverage can be a powerful tool as long as it is used responsibly. Savvy investors and companies use leverage to aid in their hedging, speculating, and expansion projects in order to create wealth, but the overly aggressive can easily get in over their heads by losing money or going into bankruptcy.

For investors considering companies with debt, one of the most popular evaluations of a company's leverage is the debt-to-equity ratio (D/E). The interest coverage ratio, also known as times interest earned, is also a measure of how well a company can meet its interest-payment obligations. In general, these ratios suggest whether a company is "too safe" and is neglecting opportunities to magnify earnings through leverage or is overleveraged and at serious risk of default or bankruptcy.