What does leveraging mean?

A lot of the current crisis is attributed to the fact that firms were heavily leveraged. So what does it really mean to be leveraged?

Leveraging means taking debt to increase the profit on the equity of a company.

Take this example, you own a business and you need to invest $1000 in order to make a profit of $250. So that means the return on your money (equity) is 25%. Now, in this example suppose that for every $1000 dollars you invest in your business, you make an additional $250.

So, that means that if you can get a loan at lower than 25%, then your percentage return on your own money will be more.

For example, if you take an additional loan of a $1000 on 15%. Then at the end of the year your interest payment will be $150.

And your profit will be:

25% of $2000: $500 minus the additional interest of $150 which comes out at $350.

So that means instead of making $250 on your initial investment of $1000, you are making $350 on your initial investment of $1000. This is because you could find loans that were cheaper than the return on your capital.

Almost every company is leveraged, which means that all businesses have some amount of debt in their capital structure. The current problem arose because businesses took more debt than they could profitably manage.