Traditionally, leverage is related to the relative proportions of debt and equity, which fund a venture. The higher the proportion of debt, the more leverage.
It is a ratio that measures a company's capital structure, indicating how a company finances their assets. Do they rely strictly on equity? Or, do they use a combination of equity and debt? The answers to these questions are of great importance to investors.
Leverage= Long Term Debt/Total Equity
A firm that finances its assets with a high percentage of debt is risking bankruptcy, higher borrowing costs and decreased financial flexibility; if its performance cannot help fulfill its debt payments. If a company is highly leveraged, it is also possible that lender's may shy away from providing further debt financing fearing the viability of their investment.
The optimal capital structure for a company you invest in, depends on which type of investor you are. A bondholder would prefer a company with very little debt financing because of it lowers the risk of him losing his money.When a firm becomes over leveraged, bankruptcy can result.
Monday, April 6, 2009
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