Leverage in financial management refers to the use of borrowed funds to amplify returns from an investment or project. It is a tool used by both investors and companies to increase the potential return of an investment or project. Leverage can also refer to the amount of debt a firm uses to finance assets. There are different types of leverage, including financial leverage, operating leverage, and combined leverage.
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Financial leverage: This refers to the amount of debt a business has acquired. It is represented by the liabilities listed on the right-hand side of the balance sheet. Financial leverage lets a business continue to make investments even if its short on cash. Its usually preferred to equity financing, as it lets a business raise funds without diluting its ownership.
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Operating leverage: This can be used by businesses that have a large number of fixed assets. It can be attained through increasing revenues or profit margins. Operating leverage magnifies cash flows and returns but can also increase risk, such as insolvency.
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Combined leverage: This is a combination of financial and operating leverage. It is used to magnify returns and cash flows, but it also increases risk.
Leverage can be used to significantly increase the returns that can be provided on an investment. However, it also magnifies losses and comes with risks, such as insolvency. Investors use leverage to multiply their buying power in the market. They leverage their investments by using various instruments, including options, futures, and margin accounts.
In summary, leverage in financial management refers to the use of borrowed funds to amplify returns from an investment or project. It can also refer to the amount of debt a firm uses to finance assets. There are different types of leverage, including financial leverage, operating leverage, and combined leverage. While leverage can increase returns, it also magnifies losses and comes with risks.
