Short definition: Leverage refers to the use of borrowed money (debt) to finance an investment or project.
Explanation: Leverage can amplify both gains and losses. When an investment performs well, leverage can increase the return on equity. However, when an investment performs poorly, leverage can magnify the losses and increase the risk of financial distress or bankruptcy.
Example: A real estate investor might use leverage to purchase a property by borrowing a portion of the purchase price from a bank. If the property value increases, the investor’s return on equity will be higher due to the leverage. However, if the property value decreases, the investor could face losses exceeding their initial investment.
Additional information (optional): There are two main types of leverage: financial leverage and operating leverage. Financial leverage refers to the use of debt to finance assets, while operating leverage refers to the proportion of fixed costs in a company’s cost structure.