Posted on February 25, 2013 @ 01:01:00 PM by Paul Meagher
According to Wise Geek, we can define leverage capital as follows:
A company or institution can use its own funds plus borrowed funds for investment. This is also known as leverage capital. As long as the capital (owned assets), plus the borrowed funds are invested at a rate of return higher than the interest on the borrowed funds, the company or institution makes money. The ratio of borrowed funds to the investor's own funds is the leverage ratio.
The concept of leverage capital is important for both entrepreneurs and investors to understand.
It is important for entrepreneurs to understand because any funds an entrepreneur receives from an investor should be considered leverage capital. In other words, the money borrowed to buy an asset should generate a higher return than any interest on debt. If it does not a generate a higher return, then the borrowed money is not leverage capital; rather, it would be considered an over consumption of capital for the business.
Leverage capital is useful for investors to understand because the leverage ratio, the ratio of borrowed to owned funds, can be used to assess the risk associated with a potential investment. If an entrepreneur has $20,000 of their own money to invest, and are seeking $40,000 from an investor, then the ratio of borrowed money to owned money would be $40,000/$20,000 or 2. The higher the leverage ratio, the greater the risk; however, keep in mind that sometimes higher risk is associated with higher reward.
Investors often like to see that entrepreneurs have some "skin in the game"; that they have invested, or are prepared to invest some of their own money in the project they are seeking investment for. If you only have $1000 of your own money in the game (in the form of equity), and are seeking $100,000 then the leverage ratio is $100,000/$1000 or 100. If you have $20,000 of your own money in the game (instead of just $1000), then your leverage ratio is only 4 and there is less risk involved for an investor (the company is not "over-leveraged"). This is how a mortage loans officer might think if confronted with a home buyer who can put $1000 down on a house versus $15000 down; the latter home buyer would be considered a less risky loan candidate.
Leverage capital is an important concept in real estate investing where a person might try to leverage some of their savings so that they can buy a building to rent. If they do it right, the amount they earn through rent and deductions can be greater than the amount they pay down on debt servicing. If so, they are leveraging their capital.