In the business world, there are many people who have a lot of money. They can make investments and accumulate wealth, but good opportunities aren't always obvious, or easy to come across. Sometimes you may not have the funds to buy into a great opportunity. And at others, you may simply want to increase your exposure to the potential upside on a deal.
For millennia, people have utilised leverage as a technique in both investing and negotiating since borrowing from those with more authority can offer those with less power an edge.
Debt is bad, we've all heard. But it isn't always so. Debt can be used to establish credit, purchase a home, or even leveraged to make a profit. Leveraging is when you use borrowed money — such as loans, securities, capital, or other assets — to make an investment.
What is leverage?
Leverage
- is a term used by business owners, investors, and everyday people looking to make money.
- is when you use borrowed funds to increase the potential return of an investment.
- is used by professional traders, entrepreneurs, investors, and individuals who are making big-ticket purchases.
"When making a purchase, investors can use a combination of both their own equity capital and leverage to expand the affordability of any investment," says Keith Carlson, CEO and managing partner of Roebling Capital Partners. "Simply put, debt and equity availability will always be greater than equity alone; what one can purchase using both will always be more substantial."
What can leverage be used for?
In business, there are five main ways you can use leverage:
1. ) As a quick and easy way to finance business acquisitions or investments
Leverage is a financial term that refers to the use of borrowed money as a means for increasing potential profits. In other words, leverage can be used to increase the net worth of an individual or business entity. There are many different ways in which people and organizations can employ leverage in order to improve their investments and returns on investments. Some examples would include using credit cards, taking out loans, borrowing from friends or family members, using margin trading strategies in securities markets, buying stocks with borrowed funds (i.e., purchasing stock on margin), and acquiring businesses with high levels of debt relative to equity capitalization. When leveraged at appropriate levels and under prudent conditions, these methods can provide significant benefits over time.
2.) An alternative to traditional equity financing for certain types of assets
It’s important to know that there are alternatives to traditional equity financing for certain types of assets.
For example, if you have a property on which you owe more than it is worth, you might want to consider an alternative like mortgage buyback. A mortgage buyback will allow the borrower to sell his or her home at a reduced price and simultaneously pay off the remaining balance on their existing mortgage loan. The homeowner would then be free from any further responsibility for this loan. This can be very helpful in some cases because it allows people who are underwater with their mortgages to move elsewhere without having all of their equity tied up in one property. Of course, there are many other types of loans and financing options available so make sure you do your research and find the right alternative for your situation.
3.) Extending credit availability in order to expand your customer base through cash-flow based lending
Leverage is the power of control over a situation. It’s what you have when you can use one thing to produce an effect or outcome that would be difficult or impossible to produce without it. In other words, leverage makes things happen. For example, if your company needs an additional $10 million in financing but can only come up with $5 million in cash from its current resources, the company might borrow the remaining $5 million by selling bonds and using the proceeds for new investments. The result: a business expansion that otherwise couldn't happen because there were insufficient funds available from internal sources alone. Leveraging means putting something at risk to get something else of greater value in return-but this doesn't necessarily mean applying pressure! When you think about it, you're leveraging all the time.
4.) Tax benefits that can help reduce costs associated with borrowing money from banks and other lenders
In a time of rising interest rates, everyone is looking for ways to reduce costs associated with borrowing money. One way to do this is through leveraging tax benefits that can help you get better deals on loans and interest rates.
Taxes have the potential to either add or save you money over the life of a loan, depending on how they are handled. Saving money in one part of your financial life will lead to having more available funds in another area. Among these benefits are: 1) deducting points at closing; 2) deducting certain settlement fees; 3) deducting points paid during the year (instead of when filing taxes); 4) capitalizing mortgage insurance premiums; 5) deferring income by putting off paying taxes until next year.
5.) Reduce the risk of an investment or acquisition by sharing it with other investors or lenders that are providing financing for the project.
This is one of the best ways to use leverage because it reduces the risk associated with an investment. It also allows you to share your profits, which means that each investor will have a smaller percentage of the total return on his or her initial capital contribution. You can offset this by requiring investors who want larger returns to contribute more money upfront.
Disadvantage of Leverage
Leverage is a complex tool. Leverage can be profitable in theory and in practice, but it can also be detrimental. Leverage amplifies gains and loss. With leverage, an investor's loss is much greater than if they had not leveraged the investment.
For this reason, new investors should avoid using leverage until they gain more experience. Investors lose money if a company fails to use leverage to generate wealth for its shareholders.
Conclusion
While leverage can increase returns, it can also increase losses. Understanding the risks can help you decide whether using leverage is right for you and your finances, and which investments to use it for.
The five ways we talked about here are only scratching the surface on how to use this tool effectively and it should give you plenty of ideas about where else you might want to apply them in your own life.
