Leverage

Leverage refers to the use of debt to increase the return on one's own capital. Those who invest with borrowed money can, if successful, lever the return on the equity invested. However, as leverage increases, the risks also grow. The mechanism is easy to describe: where the return on total capital exceeds the cost of debt, every additional unit of debt raises the return on equity. Where it falls below, the effect reverses and losses are levered too.

An example: if a company is bought for 100, with 40 equity and 60 debt, and value rises to 130 while 20 of debt is repaid, equity is worth 90 and has more than doubled, even though enterprise value rose only 30 percent. Financial leverage should be distinguished from operating leverage, which stems from the fixed cost base and amplifies earnings swings when revenue changes. The two work multiplicatively, which is why a business with high fixed costs should carry less debt. In transaction practice leverage is measured mainly as net financial debt to EBITDA, supplemented by interest and debt service cover.

The ceiling is set not by theory but by the credit market, which is why valuation levels in leveraged buyouts move with the availability of credit. In practice the limit is less a question of theory than of resilience in a downturn: what matters is how much decline in revenue and margin the structure tolerates before covenants are breached, which is why every financing is modelled in a downside case. Maturity also needs consideration, since refinancing in a weak market is considerably more expensive or fails entirely. High leverage with short tenors is therefore a double risk.