We often hear the term “leverage” in finance, but what is exactly meant by it? Generally speaking, it means to multiply your results by using a limited amount of capital. For example, say you want to purchase an office building for $1 million, but you only have $250,000. You can leverage your $250,000 by obtaining a $750,000 loan, therefore, having enough money to buy the building. Thus, in finance, leverage typically means assuming some amount of debt!
How we assess leverage is different depending on the situation. In business lending, typically loans are either commercial real estate (like an office building), or something unrelated to real estate (like a line of credit). With real estate, we measure leverage with a loan-to-value (LTV) ratio. For example, many home loans are done with 20% to 5% down payments, resulting in 80%-95% LTV. Now that is high leverage! In commercial real estate, we try to cap most projects at an LTV of 75%.
For non-real estate transactions, we focus more on the business’s balance sheet. We like to compare the net worth of the company to the total amount of loans and bills due; or in other words, their total liabilities. We again look at this as a ratio of debt-to-net worth. This tells us how much capital is funding the company compared to how much comes from borrowings. Say a company has $5 in net worth and $2 in debt. Their total assets will equal $7, most of which is funded by the company’s own capital. The debt-to-net worth ratio is 2/5 = 0.40x. We consider that low leverage. Now assume that same company goes out and borrows $8 to buy new equipment, and net worth stays the same. Now the combined debt comes to $10, and the debt-to-net worth ratio is 10/5 = 2.00x. We consider that high leverage, since they have to virtually borrow $2 for every $1 in capital!
How much leverage real estate or a company can assume largely depends on details. Like we saw, residential real estate can have higher leverage than commercial real estate. Companies that require a lot of equipment and fixed assets generally do better with low leverage; whereas, contractors and service providers can operate more successfully with higher leverage.
You might be surprised to find that banks and credit unions are very highly leveraged companies. Most of them have roughly $10 in liabilities for every $1 in capital. That is a debt-to-net worth ratio of 10.00x. This is why failing to get paid on loans quickly leads to failure. Consider capital of $1 and liabilities of $10 equals $11 in assets, and if only $1 in loan assets goes bad, then the institution has run out of capital and the regulators will shut it down!
Hopefully, you understand by now that leverage is a double-edged sword. It helps people and businesses do more with limited capital, but assuming that leverage makes problems more serious if they occur. Where regulators and the government feel they should draw the line on the maximum acceptable leverage for everyone is a matter of constant debate, as well as whether they should have the right to make that decision at all.