Leverage: Difference between revisions

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(Clarify that the slots are not owned by the airline. Source: The Treasurer, February 2017, p25.)
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==Leverage calculation==
==Financial leverage calculation==


Leverage is most commonly defined as debt divided by Debt plus Equity
Financial leverage is most commonly defined as debt divided by Debt plus Equity


= D / (D + E).
= D / (D + E).
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<span style="color:#4B0082">'''''Example 1: Leverage calculation'''''</span>
<span style="color:#4B0082">'''''Example 1: Leverage calculation'''''</span>


If the amounts of debt and equity were equal then leverage under this definition would be calculated as:<br />
If the amounts of debt and equity were equal then leverage under this definition would be calculated as:
 
1 / (1 + 1) = 50%.
1 / (1 + 1) = 50%.


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==Broader definitions==
==Broader definitions==


The term 'leverage' is also used in a broader sense to refer to the amount of debt in a firm's financial structure.<br />
The term 'leverage' is also used in a broader sense to refer to the amount of debt in a firm's financial structure.
Used in this broader sense, 'leverage' means very much the same as 'gearing'. <br />
 
It may also refer to the amount of fixed costs - as opposed to variable costs - in the firm's cost structure.
 
Used in these broader senses, 'leverage' means very much the same as 'gearing'.  
 
However, leverage and gearing are normally quantified by different calculations.
However, leverage and gearing are normally quantified by different calculations.
When not quantified, 'leverage' may also imply relatively higher levels of debt finance.




==Leveraging up==
==Leveraging up==


To 'leverage up' means to increase the level of gearing in an operational or financial structure.  The intention of leveraging up is to improve expected net results.  <br />
To 'leverage up' means to increase the level of gearing in an operational or financial structure.  The intention of leveraging up is to improve expected net results.
A consequence of leveraging up is normally to increase financial risk.<br />
Many financial disasters have been a consequence of leveraging up excessively in this way in earlier periods.


A consequence of leveraging up is normally to increase financial risk.


<span style="color:#4B0082">'''''Example 2: Virgin's loan notes secured on Heathrow landing slots'''''</span>
Many financial disasters have been a consequence of leveraging up excessively in this way in earlier periods.
 
:"Virgin Atlantic Airways secured an impressive £220m senior secured note transaction using the airline's [rights to use] take-off and landing slots at London Heathrow Airport. It is the first time in European air travel history that airport slots have been leveraged in this way."


:''The Treasurer magazine, February 2017 p25 - Deals of the Year - Bonds below £500m winner.''
The opposite process - reducing financial risk - is known as deleverage.




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<span style="color:#4B0082">'''''Example 3: Leverage in derivatives trading'''''</span>
<span style="color:#4B0082">'''''Example 2: Leverage in derivatives trading'''''</span>


10:1 leverage means that an investor needs to provide GBP 10,000 in order to control a position of a GBP 100,000 value futures contract while taking responsibility for any losses or gains their investments incur. <br />As a result if the value of the contract rose by 10% to GBP 110,000, there will be a potential profit of 100% (= 10 x 10%) relative to the amount of GBP 10,000 invested.<br /><br />
10:1 leverage means that an investor needs to provide GBP 10,000 in order to control a position of a GBP 100,000 value futures contract while taking responsibility for any losses or gains their investments incur. <br />As a result if the value of the contract rose by 10% to GBP 110,000, there will be a potential profit of 100% (= 10 x 10%) relative to the amount of GBP 10,000 invested.<br /><br />
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It is also possible to lose more than the entire value of the initial investment.<br />
It is also possible to lose more than the entire value of the initial investment.<br />
This is why derivatives trading can be so dangerous for the investor.
This is why derivatives trading can be so dangerous for the investor.
==Making fuller use of existing assets==
Leverage can also mean making better or fuller use of an existing asset. 
For example, identifying additional assets to use as borrowing collateral.
<span style="color:#4B0082">'''''Example 3: Virgin's loan notes secured on Heathrow landing slots'''''</span>
:"Virgin Atlantic Airways secured an impressive £220m senior secured note transaction using the airline's [rights to use] take-off and landing slots at London Heathrow Airport.
:It is the first time in European air travel history that airport slots have been leveraged in this way."
:''The Treasurer magazine, February 2017 p25 - Deals of the Year - Bonds below £500m winner.''
==Leverage as strong negotiating position==
In the context of negotiations, leverage refers to the relative negotiating strength of a party.




== See also ==
== See also ==
* [[Collateral]]
* [[CRD IV]]
* [[Debt]]
* [[Debt]]
* [[Deleverage]]
* [[Deleverage]]
* [[European Leveraged Finance Association]]
* [[Equity]]
* [[Equity]]
* [[Financial risk]]
* [[Gearing]]
* [[Gearing]]
* [[Leverage Ratio]]
* [[Leverage Ratio]]
* [[Leveraged]]
* [[Leveraged buyout]]
* [[Leveraged finance]]
* [[Leveraged takeover]]
* [[Liquidity]]
* [[Liquidity risk]]
* [[Liquidity risk]]
* [[Note]]
* [[Prudential Regulation Authority]]
* [[Prudential Regulation Authority]]
* [[Security]]
* [[Stability]]
* [[Stability]]




==Other links==
==Other resource==
[http://www.treasurers.org/node/8012 Masterclass: Measuring financial risk, The Treasurer, July 2012]
[http://www.treasurers.org/node/8012 Masterclass: Measuring financial risk, ''Will Spinney'', The Treasurer]


[[Category:Corporate_finance]]
[[Category:Corporate_finance]]

Latest revision as of 04:44, 21 July 2022


Financial leverage calculation

Financial leverage is most commonly defined as debt divided by Debt plus Equity

= D / (D + E).


Example 1: Leverage calculation

If the amounts of debt and equity were equal then leverage under this definition would be calculated as:

1 / (1 + 1) = 50%.


Broader definitions

The term 'leverage' is also used in a broader sense to refer to the amount of debt in a firm's financial structure.

It may also refer to the amount of fixed costs - as opposed to variable costs - in the firm's cost structure.

Used in these broader senses, 'leverage' means very much the same as 'gearing'.

However, leverage and gearing are normally quantified by different calculations.


When not quantified, 'leverage' may also imply relatively higher levels of debt finance.


Leveraging up

To 'leverage up' means to increase the level of gearing in an operational or financial structure. The intention of leveraging up is to improve expected net results.

A consequence of leveraging up is normally to increase financial risk.

Many financial disasters have been a consequence of leveraging up excessively in this way in earlier periods.

The opposite process - reducing financial risk - is known as deleverage.


Leverage in banking

Banks tend to have very high levels of leverage, compared with non-financial corporates.

Maximum levels of leverage are established by prudential regulation, including regulatory leverage ratios.


Leverage ratios in banking are usually defined as the ratio of total balance sheet assets to equity.


Leverage in derivatives trading

Leverage is also the ratio of the total value of a derivatives contract relative to the size of the required margin or collateral.


Example 2: Leverage in derivatives trading

10:1 leverage means that an investor needs to provide GBP 10,000 in order to control a position of a GBP 100,000 value futures contract while taking responsibility for any losses or gains their investments incur.
As a result if the value of the contract rose by 10% to GBP 110,000, there will be a potential profit of 100% (= 10 x 10%) relative to the amount of GBP 10,000 invested.

Similarly if the value were to fall by 10% to GBP 90,000, there would be a loss of the all the initial investment.
Again the change in the value of the total position is 10 x the 10% movement in the value of the contract.
In this case, a loss of 10 x 10% = 100%.

It is also possible to lose more than the entire value of the initial investment.
This is why derivatives trading can be so dangerous for the investor.


Making fuller use of existing assets

Leverage can also mean making better or fuller use of an existing asset.

For example, identifying additional assets to use as borrowing collateral.


Example 3: Virgin's loan notes secured on Heathrow landing slots

"Virgin Atlantic Airways secured an impressive £220m senior secured note transaction using the airline's [rights to use] take-off and landing slots at London Heathrow Airport.
It is the first time in European air travel history that airport slots have been leveraged in this way."
The Treasurer magazine, February 2017 p25 - Deals of the Year - Bonds below £500m winner.


Leverage as strong negotiating position

In the context of negotiations, leverage refers to the relative negotiating strength of a party.


See also


Other resource

Masterclass: Measuring financial risk, Will Spinney, The Treasurer