Leverage and Risk

The most obvious risk of leverage is that it multiplies losses. 

• A corporation that borrows too much money might face bankruptcy during a business downturn, while a less-levered corporation might survive. 
• An investor who buys a stock on 50% margin will lose 40% of his money if the stock declines 20%.

There is an important implicit assumption in that account, however, which is that the underlying levered asset is the same as the unlevered one.

• If a company borrows money to modernize, or add to its product line, or expand internationally, the additional diversification might more than offset the additional risk from leverage.  
• Or if an investor uses a fraction of his or her portfolio to margin stock index futures and puts the rest in a money market fund, he or she might have the same volatility and expected return as an investor in an unlevered equity index fund, with a limited downside.

So while adding leverage to a given asset always adds risk, it is not the case that a levered company or investment is always riskier than an unlevered one. In fact, many highly-levered hedge funds have less return volatility than unlevered bond funds, and public utilities with lots of debt are usually less risky stocks than unlevered technology companies.

Popular risks

There is a popular prejudice against leverage rooted in the observation that people who borrow a lot of money often end up badly. But the issue here is those people are not leveraging anything, they're borrowing money for consumption.

In finance, the general practice is to borrow money to buy an asset with a higher return than the interest on the debt. That at least might work out. People who consistently spend more than they make have a problem, but it's overspending (or underearning), not leverage. The same point is more controversial for governments.

People sometimes borrow money out of desperation rather than calculation. That also is not leverage. But it is true that leverage sometimes increases involuntarily. When Long-Term Capital Management collapsed with over 100 to 1 leverage, it wasn't that the principals tried to run the firm at 100 to 1 leverage, it was that as equity eroded and they were unable to liquidate positions, the leverage level was beyond their control. One hundred to one leverage was a symptom of their problems, not the cause (although, of course, part of the cause was the 27 to 1 leverage the firm was running before it got into trouble, and the 55 to 1 leverage it had been forced up to by mid-August 1998 before the real troubles started).  But the point is the fact that collapsing entities often have a lot of leverage does not mean that leverage causes collapses.

Involuntary leverage is a risk.  It means that as things get bad, leverage goes up, multiplying losses as things continue to go down. This can lead to rapid ruin, even if the underlying asset value decline is mild or temporary.  The risk can be mitigated by negotiating the terms of leverage, and by leveraging only liquid assets.




Forced position reductions

A common misconception is that levered entities are forced to reduce positions as they lose money. This is only true if the entity is run at maximum leverage.

The point is that it is using maximum leverage that can force position reductions, not simply using leverage. It often surprises people to learn that hedge funds running at 10 to 1 or higher notional leverage ratios hold 80 percent or 90 percent cash.


Model risk

Another risk of leverage is model risk. Economic leverage depends on model assumptions.  If that assumption is incorrect, the fund may have much more economic leverage than it thinks. For example, if refinery capacity is shut down by a hurricane, the price of oil may fall (less demand from refineries) while the price of gasoline might rise (less supply from refineries). A 5% fall in the price of oil and a 5% rise in the price of gasoline could wipe out the fund.

Counterparty risk

Leverage may involve a counterparty, either a creditor or a derivative counterparty. It doesn't always do that, for example a company levering by acquiring a fixed asset has no further reliance on a counterparty.

In the case of a creditor, most of the risk is usually on the creditor's side, but there can be risks to the borrower, such as demand repayment clauses or rights to seize collateral.  If a derivative counterparty fails, unrealized gains on the contract may be jeopardized. These risks can be mitigated by negotiating terms, including mark-to-market collateral.

http://en.wikipedia.org/wiki/Leverage_(finance)

Leverage

Using OPM (other people's money) to make money is smart business as long as the company doesn't go over its head in debt.

From the perspective of a shareholder, the more revenue-producing assets a company can put into play without requiring more money from the shareholders, the better.

The downside, of course, is the vulnerability issue and what creditors might do if the income dries up enough to make servicing the debt difficult or impossible.

Common ratios to evaluate leverage are:

1.  Debt to Assets (Total Debt / Total Assets)
2.  Assets to Equity (Total Assets / Shareholder Equity)
3.  Debt to Equity (Total Debt / Shareholder Equity)
4.  Debt to Capital (Long-term Debt / Total Capitalization)


Don't base an investment solely on any of the ratios above.  Their most useful purpose could be to call your attention to possible upcoming changes in your quality criteria and might lead you to be more vigilant about them as you manage your portfolio.



Debt Service

For those companies with high leverage, you should also look at their ability to service their debts.  For this, look at these ratios:

1.  Interest Coverage (EBIT / Interest)
2.  Interest and Principal Coverage  [EBIT / (Interest + Adjusted Principal Repayments)]

Definition of 'Leverage Ratio'

Any ratio used to calculate the financial leverage of a company to get an idea of the company's methods of financing or to measure its ability to meet financial obligations. There are several different ratios, but the main factors looked at include debt, equity, assets and interest expenses.

Investopedia explains 'Leverage Ratio'

The most well known financial leverage ratio is the debt-to-equity ratio. For example, if a company has $10M in debt and $20M in equity, it has a debt-to-equity ratio of 0.5 ($10M/$20M).

Read more: http://www.investopedia.com/terms/l/leverageratio.asp#ixzz2ALwlASAr

Two important things in the capital structure of the business

Capital Structure

When looking at capital structure, try to determine two things:

1. Is the business a consumer or producer of capital? Does it constantly require capital infusions to build growth or replace assets? Warren Buffett - and many other value investors - shun businesses that cannot generate sufficient capital on their own. In fact, one of the guiding principles behind Berkshire Hathaway is the generation of excess capital by subsidiary businesses that can be deployed elsewhere.

2. Is the business properly leveraged? Overleveraged businesses are at risk and additionally burden earnings with interest payments. Under-leveraged businesses, while better than overleveraged, may not be maximizing potential returns to shareholders.