What Is Leverage?

I’ve been having conversations with friends about leverage. One thing I’ve picked up on is that leverage doesn’t mean the same thing to everyone. With a little digging, I found definitions used by Joel Greenblatt, founder of Gotham Asset Management, that I think are pretty accurate:

  • Financial leverage – The amount of debt a company has taken on relative to its equity. It can lead to higher returns for shareholders if the company can earn a higher return on the money borrowed than it cost to borrow it.
  • Investment leverage by borrowing – Money borrowed by an investor for the purpose of purchasing an investment.
  • Investment leverage by contract – A payment by an investor of a (relatively) small amount up front to purchase the right to purchase an asset later.

These are straightforward ways to think about what leverage is. We can see, thinking about these definitions, that a lot of people and companies use leverage in some form or fashion.