I wish I knew what leverage was, but I’m too embarrassed to ask

Leverage (or “gearing”) refers to the extent to which debt rather than equity is used to fund an investment. The term can be applied to a business – that might issue bonds to help pay for the construction of a new factory or take out a mortgage to allow it to buy an office building – but equally for the use of borrowings by an investment trust or hedge fund to increase returns.

Leverage is also known as gearing; the latter term is more common in the UK, while the former is preferred in the US. The extent of a company’s leverage can be measured through ratios such as debt/ equity. Let’s assume that a company has assets worth £100m and debt totalling £30m. Shareholders’ equity, which is equal to assets minus liabilities, will be £70m. Then its debt/ equity ratio is 30 ÷ 70 = 43%. The debt/assets ratio, another common measure of leverage, will be 30 ÷ 100 = 30%.

The company then buys a rival for £50m and finances the deal using a bank loan. Total assets are now £150m, debt is £80m and equity is unchanged at £70m. However, its debt/ equity ratio is now 80 ÷ 70 = 114% and its debt/assets ratio is 80 ÷ 150 = 53%. It is now more highly leveraged. You should also look at interest cover, which is earnings before interest and tax (Ebit) divided by interest payable. So if the firm had Ebit of £5m and paid £2m in interest, it would have interest cover of 5 ÷ 2 = 2.5.

Leverage for a fund is usually calculated in a similar way to debt/assets. Say an investment trust has £100m in capital contributed by investors, borrows £5m and invests £105m. It will then start with gearing of 5%, which will change in line with the value of the investments.

For individuals in the UK, leverage for investing (rather than buying a house, say) is most easily accessed using spreadbetting. This can amplify your returns but, of course, it can amplify your losses too, and is thus best avoided if you are at all unsure about how it works.