Leverage..18 May 2018 05:52
First off H you need to look at a Cos income statement to see if their economic firepower requires leverage to make money. In a nutshell those that did not...ie had a competitive advantage or those that struggled needing constant blood transfusions that made them poor investments to turn a coin. It's the source of earnings not the earnings themselves that's important, exemplified by the Nile river. Without the source...nothing.
So down to the nitty gritty. Simply put 'leverage' is the use of debt to increase the earnings of a Co. For instance a Co borrows £100m at say 7% and puts the cash to work where it might earn 12% giving it
5% in excess of costs. The result £5m goes to the bottom line boosting earnings and return on equity...NICE. Really all your doing is buying something you can't wholly pay for and that can lead to trouble...ask World.com. Mind you when it works...happy days as it magnifies your gains making you look very clever..."gotta new motorJohn?" Here's the drawback. Leverage can make a Co seem to have a competitive advantage when patently it has not. Banks are notorious for using leverage, lending borrowed money at x% points above cost to make money. Drawback (2). The source of money may not be able to maintain lending, especially in times of economic stress thus causing defaults when they stopped loaning which leads to the borrowers getting into shtuck (see sub prime mortgages) and the subsequent fall out. So best avoid Cos that use lots of leverage to help them to generate earnings. Big ftse Cos are adept at using leverage (they have departments full of people managing their risk) but it aint for all for sometimes the golden eggs turn out rotten. Morning all.
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