Definition of Leverage—Profits and Financial Risk
An important concept in understanding the relationships in the financial
structure of the firm is the ancient idea of “trading on the equity,” now go-
ing under the current term “leverage.”^1 Leverage is the amount of outside
funds (debt) the owners use in proportion to their own contributions to the
financing of the firm. The use of debt is called leverage because these funds,
acquired at a priority of repayment and given a priority of return, widen
the potential swing of both gains and losses to the ownership shares. Any
earnings on the assets acquired by borrowing in excess of the rate that has
to be paid to the creditors belongs to the owners and increases their net
rate of return; however, if the earnings on the assets acquired with bor-
rowed funds fall below the contracted rate or if there are overall losses, the
negative difference sharply reduces the rate of return or increases the loss
on the equity. But as long as the marginal assets employed in the firm earn
more than the cost of the borrowed funds, it will be profitable to use lever-
age, with the proviso that the financial risk of the firm is not thereby inor-
dinately increased. In the King’s English, if a corporation can borrow funds
at 5 percent interest, and invest those funds into assets that generate 10
percent return on assets, then clearly the firm’s stockholders earn the differ-
ential return and are compensated for bearing risk. The degree of leverage
in a firm’s capital structure is measured by noting how much the rate of re-
turn on equity would change with any change in the average rate of return
on the total assets. The greater the proportion of outside funds to owner-
ship capital, the more emphatic is the leverage effect.
Some financial analysts apparently recognize leverage only if the out-
side funds are acquired under a definite contract and the suppliers of these
funds are paid a fixed positive rate of return. Leverage is thus limited to the
use of bonds, preferred stock, or long-term bank loans. Under this concept
many banks, for example, are not considered as leveraged, since they often
have no bonds or preferred stock outstanding in their capital structure.
Nevertheless, authorities in the field of money and banking note the “highly
leveraged aspect” of the typical bank’s capital structure, the small percent-
age of equity in comparison to the total deposits or liabilities carried.
A broad definition of leverage covers the relationship between all the
prior claim securities or obligations and the ownership capital. Trade ac-
counts and other current liabilities are included in this concept of leverage.
These obligations have priority over the ownership shares; they must be
paid at least a zero rate of return. This seems a paradox until we remember
that ours is a profit-and-loss economy. Shareholders may earn a negative
rate of return and the owners may absorb losses, but liability claims are