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Leverage is what is mostly used in real estate transactions for the purpose of purchasing a home through mortgages. Defined in dictionaries it means the use of various financial instruments or borrowed capital, such as margin, to increase the potential return of an investment. It also means the amount of debt that is used to finance a firm’s assets. A firm with significantly more debt than equity is considered to be highly leveraged.

Leverage can be created through options, futures, margin and other financial instruments. For example, if we have a $100 to invest in any manner and we invest them in 10 shares of Microsoft stock. To increase the leverage of the stock we could invest them in just five contracts and end up controlling 500 shares instead of just 10.

What is Leverage There are companies that use debts to finance their operations. In this manner, these companies increase their leverage as it can invest in more business operations by using this debt and not increasing their equity. For example, if a company is formed with an investment of $10 million from investors, the equity in the company is $10 million which is the money with which the company operates. If the company uses debt financing by borrowing $20 million, then the company has $30 million to invest in business operations.

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Leverage helps both the investor and the firm to invest and operate. But it involves a high amount of risk. Leverage magnifies both gains and losses. If an investor uses leverage to make an investment and the investment goes against the investor then it results in a greater loss than what he would have incurred in case of a leveraged stock. In the business world, a company can use leverage to try to create a huge shareholder wealth and if it fails to do so, then the interest expense and credit risk of default destroys the shareholder value.

Leverage also refers to borrowing. If a business is leveraged, it means that the business has borrowed money to finance the purchase of assets as the only other way of purchasing assets is through use of owner funds or equity. Leverage can be determined by calculating the debt-to-equity ratio showing how much of the assets of the business have been financed by debt and how much by equity. Leverage is not a bad thing, it’s good for company growth.

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