The answer: volatility or risk increases for equity holders when leverage increases. How come? To be more specific, the use of financial leverage means increasing debt. Of course, the increase in debt adds more risk. Once the debt cannot be repaid when it is due, the company will face bankruptcy. Let’s see more details about this situation.
What Is Financial Leverage?
What is financial leverage? Just like what mentioned above, the use of financial leverage is actually an increasing debt. To be more accurate, financial leverage is using borrowed capital as a funding source so as to expand the firm’s asset base and generate returns on risk capital.
To put it more simple, leverage is an investment strategy by using borrowed money to increase the potential return of an investment. Leverage can also indicate the amount of debt a firm uses to finance assets.
The concept of leverage is applied in both investors and companies. Investors use leverage to magnificently increase the returns provided on an investment. They use various instruments, such as options, futures, and margin accounts to lever investments.
As for companies, they use leverage to finance their assets. In other words, companies can use debt financing to invest in business operations to increase shareholder value.
Individuals who are not comfortable using leverage directly have various ways to access leverage indirectly. They can invest in companies that use leverage in their normal business routine to finance or expand operations—without increasing their outlay.
What Is Equity Holder?
An equity holder is a broad term any person who has a stake of ownership in a business can be in. It includes shareholders and any person who has ownership interest. Equity holders are common in sole proprietorships. In a word, the sole business owner is definitively equity holder, but it doesn’t work vice versa.
Leverage is used to multiply the potential returns from a project. At the same time, leverage will also multiply the potential like an excessive consumption. When one says a company, property, or investment “highly leveraged,” it means that item has more debt than equity.
Advantages of Leverage
Investors and traders use leverage to amplify profits as much as they can. Using leverage allows them to access more expensive investment options. Leverage can be used and often used in short-term, low risk situations where high degrees of capital are needed. For example, a developing company may have a short-term need for capital.
And the leverage will result in a strong and long-term growth opportunity. Compared to use additional capital to gamble on risky endeavors, leverage enables smart companies to seize the opportunities with the intention of exiting their levered position quickly.
Volatility or Risk Increases for Equity Holders When Leverage Increases
It is more than obvious that volatility or risk increases for equity holders when leverage increase. You put more money in use as a leverage, which means more debt on you. If the leverage not used reasonably, the whole asset of yours will be in danger. And even worse, you will carry debt in the rest of your life. And before the the volatility and risk happens, there are limitations of leverage.
Just like winning investments are amplified, so does the losing investments. Using leverage can result in strong downside risk, even bring in the great and strong one. Besides, extra fees will still be charged even if you lose on your trade.
Other than what mentioned above, leverage can be complex. Investors must be aware of their financial position and the risks they inherit in advance when using a leverage. This may requires their additional attention to one’s portfolio and contribution of additional capital.
In a word, be aware and careful with the increasing volatility or risk when you increase your leverage.