Financial leverage refers to the use of debt to acquire additional assets. Financial leverage is also known as trading on equity. Below are two examples to illustrate the use of financial leverage, or simply leverage.
Mary uses $400,000 of her cash to purchase 40 acres of land with a total cost of $400,000. Mary is not using financial leverage.
Sue uses $400,000 of her cash and borrows $800,000 to purchase 120 acres of land having a total cost of $1,200,000. Sue is using financial leverage. Sue is controlling $1,200,000 of land with only $400,000 of her own money.
If the properties owned by Mary and Sue increase in value by 25% and are then sold, Mary will have a $100,000 gain on her $400,000 investment, a 25% return. Sue's land will sell for $1,500,000 and will result in a gain of $300,000. Sue's $300,000 gain on her $400,000 investment results in Sue having a 75% return. When assets increase in value leverage works well.
When assets decline in value the use of leverage works against you. Let's assume that the properties owned by Mary and Sue decrease in value by 10% from their cost and are then sold. Mary will have a loss of $40,000 on her $400,000 investment—a loss of 10% on Mary's investment. Sue will have a loss of $120,000 ($1,200,000 X 10%) on her $400,000 investment. This is a loss of 30% ($120,000 divided by $400,000) on Sue's investment.
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