The use of borrowed money to fund assets, which magnifies both returns and losses for shareholders without changing the operating business at all.
Leverage raises return-on-equity whenever the business earns more on its assets than it pays in interest, and destroys it when the reverse is true. It is the third term in dupont-analysis and the reason two companies with identical return-on-assets can report very different ROE.
Combined with operating-leverage, it produces total leverage: a business with high fixed costs and high debt can turn a 10% revenue decline into a solvency event.
Example: Northwind Tools funds $1,480M of assets with $570M of equity, a multiplier of 2.6. Its 5.3% return on assets becomes a 13.7% return on equity, with borrowing supplying the difference.
Original diagrams for the ideas on this page. Illustrative, not real market data.
Margin and leverage. A $5,000 deposit can control a $100,000 position, which is 20:1 leverage. Because the loss is measured on the full $100,000, a 2.5% move against you halves the deposit and brings a margin call, and a 5% move uses all of it.
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