Levering

What Is Levering?

Levering, in the context of corporate finance and investment strategy, refers to the act of using borrowed capital to increase the potential return of an investment or a company's financial performance. It involves employing various forms of debt financing rather than relying solely on equity financing to fund assets or operations. The primary objective of levering is to amplify the returns to shareholders, often by acquiring assets that generate a higher rate of return than the cost of the borrowed funds. This financial strategy is a core component of how many businesses manage their capital structure, aiming to optimize profitability.

History and Origin

The concept of using borrowed money to enhance returns has been present in commerce for centuries, but the modern application of "levering" as a deliberate financial strategy gained significant prominence with the rise of leveraged buyouts (LBOs) in the 1980s. During this period, private equity firms and corporate raiders heavily relied on debt to acquire companies, often with the target company's assets serving as collateral. The dramatic surge in LBO activities in the 1980s was notably facilitated by the emergence of the high-yield bond market, which provided speculative-grade debt for these large acquisitions. Following a period of excess speculation and high-profile bankruptcies, the junk bond market experienced an implosion in 1989, leading to a cooling off of interest in LBOs in the 1990s. The Federal Reserve Bank of New York's Liberty Street Economics blog provides a historical perspective on this period, highlighting the volatile nature of such debt-fueled transactions⁴.

Key Takeaways

• Levering is the strategic use of borrowed funds to magnify potential investment returns or enhance a company's financial performance.
• It primarily involves utilizing debt, such as loans or bonds, instead of solely equity.
• The goal of levering is to generate a return on assets that exceeds the cost of debt, thereby increasing returns to shareholders.
• While it can boost gains, levering also inherently amplifies financial risk, as debt obligations must be met regardless of performance.
• Effective risk management is crucial when engaging in levering activities to avoid potential bankruptcy.

Formula and Calculation

While "levering" is the act of using borrowed capital, its effectiveness and extent are quantified through various leverage ratios. One of the most common financial ratios used to assess the degree to which a company is levered is the Debt-to-Equity (D/E) Ratio. This ratio indicates the proportion of shareholders' equity and debt a company uses to finance its assets.

The formula for the Debt-to-Equity Ratio is:

Where:

• Total Liabilities: Represents all financial obligations of the company, typically found on the balance sheet. These include both short-term and long-term liabilities.
• Shareholders' Equity: Represents the owners' residual claim on assets after deducting liabilities, also found on the balance sheet.

A higher ratio indicates that a company relies more heavily on debt to finance its operations and assets.

Interpreting the Levering

Interpreting the extent of levering involves understanding the trade-offs between increased potential returns and heightened risk. A company that is highly levered aims to generate a return on equity that is substantially higher than what could be achieved with equity alone. If the assets acquired with borrowed funds generate a return greater than the interest expense on the debt, the excess profit accrues to equity holders, boosting earnings per share and overall equity returns.

Conversely, significant levering can exacerbate losses if the returns generated by assets fall below the cost of debt. In such scenarios, fixed interest payments can quickly erode profits or even lead to substantial financial distress. Analysts often examine a company's income statement in conjunction with its balance sheet to assess the ongoing impact of levering on profitability and solvency.

Hypothetical Example

Consider "InnovateTech Inc.," a software company looking to expand its data center capacity.

• Scenario 1 (No Levering): InnovateTech uses $10 million of its retained earnings (equity) to build a new data center. This data center is projected to generate $1.5 million in annual net income, resulting in a 15% return on this equity investment.
• Scenario 2 (With Levering): InnovateTech decides to "lever" its expansion. It uses $2 million of its own equity and borrows $8 million at an annual interest rate of 5% (costing $400,000 in interest per year). The new data center still generates $1.5 million in annual net income.

In Scenario 2, the net income available to equity holders is $1.5 million (gross income) - $0.4 million (interest expense) = $1.1 million. The return on the $2 million equity invested is $1.1 million / $2 million = 55%.

This hypothetical example illustrates how levering can significantly amplify returns for equity holders (from 15% to 55%) by using borrowed capital, assuming the investment performs as expected and covers the cost of debt. However, it also highlights the increased fixed obligation: even if the data center generates less than $400,000, the company still owes that interest, potentially leading to losses for equity. This demonstrates the double-edged sword inherent in this investment strategy.

Practical Applications

Levering is a pervasive practice across various sectors of the financial world, from corporate finance to individual investing. In corporate finance, companies often engage in levering to fund growth initiatives, such as capital expenditure for new facilities, research and development, or mergers and acquisitions. By using debt, a company can expand operations without diluting existing shareholder ownership.

In banking and financial services, institutions employ significant levering. Banks, for instance, operate by taking deposits (a form of liability) and lending them out, essentially levering their capital base. Regulators, like the Federal Reserve, impose stringent capital requirements on banks, including leverage ratios, to ensure stability and mitigate systemic risk within the financial system³. The International Monetary Fund (IMF) also frequently highlights the increased use of leverage by nonbank financial institutions as a vulnerability that raises risks to global financial stability².

For individual investors, levering can involve using margin accounts to buy securities, effectively borrowing from a brokerage firm to purchase more stocks or other assets than they could with their cash alone. This strategy is also common in real estate, where mortgages allow individuals to buy homes with a fraction of the total cost upfront.

Limitations and Criticisms

Despite its potential to amplify returns, levering carries significant limitations and criticisms, primarily due to the magnified risk it introduces. The most critical drawback is the increased vulnerability to adverse economic conditions or business downturns. When a company is highly levered, even a minor drop in revenue or increase in operating costs can make it difficult to meet fixed debt obligations, such as interest payments, leading to severe financial distress or even bankruptcy.

Academic research has consistently shown that excessive leverage can contribute to deeper economic downturns. For instance, a National Bureau of Economic Research (NBER) working paper, "Leverage, Business Cycles, and Crises," analyzed data from advanced economies over a long period, finding that a stronger increase in financial leverage during a boom tends to lead to a deeper subsequent recession¹. This suggests that while levering can fuel growth during good times, it also heightens the system's susceptibility to shocks, potentially exacerbating market volatility.

Furthermore, high levels of debt can constrain a company's strategic flexibility, limiting its ability to invest in new opportunities or respond to unexpected challenges without further increasing its debt burden. Creditors may also impose restrictive covenants on highly levered companies, dictating certain financial ratios or operational limits. In individual investing, margin calls are a common risk where a sudden drop in asset value can force an investor to deposit more funds or sell their holdings at a loss to cover the borrowed amount.

Levering vs. Leverage

While often used interchangeably, "levering" and "leverage" refer to distinct but related concepts.

• Levering is the action or process of using borrowed capital. It describes the act of a company or individual taking on debt to finance assets or operations with the aim of increasing returns. For example, a company is "levering its balance sheet" when it issues new bonds.
• Leverage is the result or state of having used borrowed capital. It refers to the degree to which a company or investment is financed by debt rather than equity. It is a measurement, often expressed as a ratio (like the Debt-to-Equity Ratio), indicating the amount of debt relative to equity or assets. For instance, a company "has high leverage" if its debt-to-equity ratio is elevated.

In essence, levering is the verb—the strategic decision and implementation—while leverage is the noun—the resulting financial structure and its associated effects. One performs the act of levering to achieve a certain level of leverage.

FAQs

Why do companies engage in levering?

Companies engage in levering primarily to boost the potential return on equity for their shareholders. By using borrowed capital, they can acquire more assets or undertake larger projects than they could with equity alone, and if these investments generate returns higher than the cost of debt, the profits accrue to equity holders.

What are the main risks associated with levering?

The main risks include amplified losses if investments perform poorly, the obligation to make fixed interest payments regardless of profitability, and the increased chance of bankruptcy during economic downturns. It can also lead to reduced financial flexibility.

Can individuals engage in levering?

Yes, individuals engage in levering through various means, such as taking out mortgages to purchase real estate or using margin trading accounts to buy securities. The principle remains the same: using borrowed money to increase potential returns.

How is the degree of levering measured?

The degree of levering, or leverage, is typically measured using financial ratios like the Debt-to-Equity Ratio or the Debt-to-Assets Ratio. These ratios provide insight into the proportion of a company's assets financed by debt.

Is levering always a bad thing?

No, levering is not inherently bad. When used prudently, it can be a powerful tool for growth and value creation. Many successful companies strategically use debt to fund expansion or optimize their capital structure. The key lies in balancing the potential for enhanced returns with the associated risks.