Leverage is the indebtedness of a company, or the process of increasing the indebtedness of a company (as in the phrases “highly leveraged company” or “acquiring leverage”). It is usually measured by one of two gearing ratios. Capital or financial gearing is the amount of debt that a company has relative to its total capital. Alternatively, income gearing is the ratio of a company’s debt to its total income.
Until the twentieth century, income gearing was the common measure of leverage. This reflected a corporate practice in which the only possible gainful use of debt—that is, aside from its traditional unproductive use in financing consumption or government—was to finance commerce or industry. It followed that the key indicator in determining the amount of borrowing was the possible income that it might generate in trade or production.
With the emergence of active markets in corporate finance toward the end of the nineteenth century in Britain and the United States, the scope for the gainful employment of leverage extended beyond commerce and industry, and into the capital market itself. Once that market became sufficiently large, the return from profitable trade in it was determined by the total amount of capital that could be turned over in that market. In these circumstances, the major consideration was no longer possible future income in trade or production, because these are irrelevant in determining income from arbitraging in the capital market, but the amount of capital that could be applied to a profitable arbitrage. That amount of capital, and hence the income from it, was maximized by adding borrowing to equity. From this emerged the measure of leverage common today, namely the ratio of debt to total capital.
The roots of this change in definition, in the changing business of finance, was obscured in the 1950s by the famous Modigliani-Miller theorem, which claimed to prove that the value of a corporation is not affected by the division of its capital into equity and debt. But this is under the assumption of a perfect capital market, with no arbitrage possibilities, so that the return on debt was ultimately provided by income from commerce or industry, rather than further financial transactions. The “theorem” set off a number of hares in the academic finance literature to determine whether variations in leverage were caused by capital market imperfections or differences in the tax treatment of interest on debt, as opposed to the tax liability on the return to equity.
By the mid-2000s it was increasingly recognized that the business opportunities available to a company and its liquidity are clearly affected by its leverage. A company with $1 million of equity, tied up in productive equipment and work in progress, is a relatively illiquid company that may experience financial difficulties if a larger than expected bill needs to be paid. That same company with an additional $10 million of debt invested in the money market is a highly liquid company that can cope with larger-than-expected payments. Such a company can undertake new projects without having to waste management time in finding financial backers. Most importantly, it can itself engage in speculative buying and selling of companies in the capital market without reducing its liquidity, as long as that market stays liquid. With the expansion of capital market financing beyond the United States and United Kingdom into Europe and emerging markets elsewhere, leverage is becoming an increasingly widely used way of making medium-sized businesses into large corporations without the tedium of expanding productive or commercial capacity.
SEE ALSO Capital; Capitalism, Managerial; Corporations; Equity Markets; Finance; Financial Instability Hypothesis; Financial Markets; Liquidity; Loans; Modigliani-Miller Theorems; Overlending; Wealth
Auerbach, Alan J. 1992. Leverage. In The New Palgrave Dictionary of Money and Finance, eds. Peter Newman, Murray Milgate, and John Eatwell, pp. 574–577. London: Macmillan.
Barclay, Michael J., Leslie M. Marx, and Clifford W. Smith Jr. 2003. The Joint Determination of Leverage and Maturity. Journal of Corporate Finance 9 (2): 149–167.
Myers, Stewart C. 1977. Determinants of Corporate Borrowing. Journal of Financial Economics 5 (2): 147–175.
lev·er·age / ˈlev(ə)rij; ˈlēv(ə)rij/ • n. 1. the exertion of force by means of a lever or an object used in the manner of a lever: my spade hit something solid that wouldn't respond to leverage. ∎ mechanical advantage gained in this way: use a metal bar to increase the leverage. ∎ fig. the power to influence a person or situation to achieve a particular outcome: the right wing had lost much of its political leverage in the Assembly.2. Finance the ratio of a company's loan capital (debt) to the value of its common stock (equity).• v. [tr.] [usu. as adj.] (leveraged) use borrowed capital for (an investment), expecting the profits made to be greater than the interest payable: a leveraged takeover bid.
A method of financing an investment by which an investor pays only a small percentage of the purchase price in cash, with the balance supplemented by borrowed funds, in order to generate a greater rate of return than would be produced by paying primarily cash for the investment; the economic benefit gained by such financing.
Real estate syndicates and promoters commonly use leverage financing. A leveraged investor builds up equity or ownership in the investment by making payments on the amount of principal borrowed from a third person. The money allotted to the repayment of interest charged on the borrowed principal is treated typically as a deduction that reduces taxable income. The greater the amount of principal borrowed, the larger the interest payments and the resulting deductions. Obviously, a taxpayer who pays cash is not entitled to deductions for interest payments. In many cases, deductions for the depreciation of thecapital asset constituting the investment are also permitted.
Any investor receives an anticipated rate of return from the investment although the rate may fluctuate depending upon the economic climate and the management of the investment. Because of the favorable tax treatment enjoyed as a result of this method of financing, the leveraged investor keeps more of the income generated by the investment than an investor who financed the investment mainly through cash. There is, however, risk involved in leverage financing. If the income generated by the investment decreases, there might not be adequate funds available to meet payment of the outstanding principal and interest, leading to substantial losses for the investor.