Leverage in all its forms involves the process of magnification. Financial leverage and physical leverage are used to produce some magnified result. However, the differences are in what is magnified- income versus physical force, and what is employed as the lever- fixed costs (fixed amounts) versus a mechanical device. For example, at a proper fulcrum point, 200 pounds can be used to lift 500 pounds (physical leverage). The leverage ratio is, thus, 500/200 = 2.5. Likewise, an equity of $5 million can be used to buy $12.5 million worth of property. The leverage ratio is 12.5/5 = 2.5.
February 12, 2022