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January 28, 2009

What is financial leverage?

Financial leverage refers to the use of debt to acquire additional assets. Financial leverage is also known as trading on equity. Below are two examples to illustrate the use of financial leverage, or simply leverage.

Mary uses $400,000 of her cash to purchase 40 acres of land with a total cost of $400,000. Mary is not using financial leverage.

Sue uses $400,000 of her cash and borrows $800,000 to purchase 120 acres of land having a total cost of $1,200,000. Sue is using financial leverage. Sue is controlling $1,200,000 of land with only $400,000 of her own money.

If the properties owned by Mary and Sue increase in value by 25% and are then sold, Mary will have a $100,000 gain on her $400,000 investment, a 25% return. Sue’s land will sell for $1,500,000 and will result in a gain of $300,000. Sue’s $300,000 gain on her $400,000 investment results in Sue having a 75% return. When assets increase in value leverage works well.

When assets decline in value the use of leverage works against you. Let’s assume that the properties owned by Mary and Sue decrease in value by 10% from their cost and are then sold. Mary will have a loss of $40,000 on her $400,000 investment—a loss of 10% on Mary’s investment. Sue will have a loss of $120,000 ($1,200,000 X 10%) on her $400,000 investment. This is a loss of 30% ($120,000 divided by $400,000) on Sue’s investment.

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Comments

16 Responses to “What is financial leverage?”

  1. rana sohail on February 1st, 2009 12:29 pm

    fantistic work…….

  2. anna rose on February 4th, 2009 2:31 am

    thanks for your site, a lot of knowledge can be learn
    keep up the good work

  3. Albert on February 4th, 2009 8:06 am

    Thank you for being reliable.

  4. Joshua on February 4th, 2009 12:22 pm

    Great example! I love how you use “real world” examples with numbers to help me understand them. Keep up the great work!

  5. alberto on February 6th, 2009 10:19 pm

    if i use only a loan to buy a land, do i talk about financial leverage in this case?

  6. Bayode on February 7th, 2009 4:21 am

    Well done,great job u ar doing.what about refunding d loan.

  7. Yasser tawfiq on February 7th, 2009 4:33 pm

    Thanks for good effort.

  8. alfred on February 8th, 2009 7:26 am

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  9. Mostafiz on February 9th, 2009 5:41 am

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  10. vicky on February 10th, 2009 6:44 pm

    Great job ! I am learning and inspired to see more of your website.

    How do you classifiy waiters in a restaurant business, is it an admin or overhead cost ?
    Thanks

  11. Emmanuel on February 11th, 2009 6:48 am

    Thanks from making me to understand what is financial leverage and hoping to see more

  12. sima on February 12th, 2009 4:03 am

    if marry put download 400,000$ and she will have and gain 25% means 100,000$ = $500,000, and sue barrow 800,000 and want to sell the land for 1,500,000
    if they return the loan means, 1500,000-800,000=700,000-500,000 mary investment =200,000 sue investment from selling the land

  13. Otuekong on March 23rd, 2009 2:17 pm

    Useful assistance, great work!

  14. Subrata on July 24th, 2009 2:10 pm

    Really excellent.

  15. Leni on August 7th, 2009 4:47 am

    finally i understand what financial leverage is.

  16. Atif Kazmi on August 28th, 2009 11:34 pm

    Excellent work, keep it up.

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