Introduction
Leverage is a powerful tool that businesses use to increase their returns on investment. Leverage allows a business to borrow money (usually from a financial institution) to purchase assets, finance investments, and increase the amount of capital it has to invest. By using leverage, businesses can access additional capital, increase their return on investment, and be more competitive in the market.
The major source of leverage in businesses is debt, which is used to purchase assets with the expectation that the value of the assets will increase. This increase in value will ultimately provide the business with a greater return on investment than if the business had invested in assets without taking on additional debt. However, when businesses take on too much debt, they can become overextended and incur too much risk, resulting in potential bankruptcy.
Types of Leverage
There are several types of leverage that a business can use to increase returns on investment. The most common types are financial leverage and operating leverage. Financial leverage is the use of debt to purchase assets, including real estate, stocks, bonds, and other securities. Operating leverage is the use of fixed costs and capital investments to increase earnings. Both types of leverage are important and can be used to achieve different objectives.
Financial Leverage
Financial leverage involves the use of debt, or borrowing money, to purchase assets and increase the amount of capital available for investing. By taking on debt, a business can purchase more assets than it could without it, and these assets can potentially increase in value over time, increasing the return on investment.
However, when taking on too much debt, businesses can become overextended, resulting in increased risk and potential bankruptcy. For this reason, businesses should be cautious when considering taking on additional debt, as it is important to calculate the potential return on investment before proceeding.
Operating Leverage
Operating leverage involves the use of fixed costs and capital investments to increase earnings. By utilizing leverage, businesses are able to produce more products or services with fewer resources. This is done by managing fixed costs, such as research and development, as well as investments in assets, such as new technology. By reducing the amount of money spent on fixed costs and capital investments, businesses can increase their return on investment.
Conclusion
Leverage is an important tool for businesses to increase returns on investment. By using financial and operating leverage, businesses can purchase additional assets, finance investments, and increase their earnings without increasing the amount of capital available. It is important, however, to be aware of the risks associated with leverage and to calculate the potential return on investment before taking on additional debt.
