Investing

Lesson 33

12 min

What is the leverage effect?

Anyone involved in investing or corporate finance will quickly come across the term leverage effect: companies use it for growth – investors to maximise profits. The leverage effect offers opportunities and advantages, but also involves risks. Especially in volatile markets, such as equities and particularly cryptocurrencies, it's important to understand the mechanisms of leverage to make informed decisions.

We’ll explain in simple terms what the leverage effect is and how it works. In our guide, you'll also learn the formula to calculate it, the advantages and disadvantages it brings, and see some examples.

According to the definition, the leverage effect describes the influence of debt capital on return on equity and shows how companies and investors can increase their return through leverage.
The leverage effect is positive when the return on total capital is higher than the interest on debt, and negative when the cost of debt exceeds the return.
Through the targeted use of leverage, larger investments can be made, but the risk also increases, especially in volatile markets like cryptocurrencies.
Using leverage consciously requires a clear strategy, as both high profits and significant losses are possible.

Definition: What is the leverage effect simply explained?

The leverage effect describes the influence of debt capital on the return on equity (ROE) of a company or an investment. By deliberately using debt, returns can increase as long as the overall return on capital exceeds the interest on the borrowed funds. However, the leverage effect can also turn negative if the return on capital isn’t enough to cover the cost of debt.

The term "leverage" means "lever". It refers to the strategy of financing investments with borrowed capital to use equity more efficiently. Companies use the leverage effect to grow faster, while investors use it to take larger market positions with a smaller capital outlay. The idea isn’t new: even in classical corporate finance, debt was deliberately used to optimise return on equity. Today, the leverage effect plays a role not only in equities and stocks but also in modern markets like crypto trading.

The types of leverage effect

The leverage effect can be positive, negative or neutral. A positive leverage effect arises when the return on total capital is higher than the interest on debt, boosting the return on equity. A negative leverage effect occurs when the return on capital is below the cost of debt, reducing the return on equity. The leverage effect can also be broken down into specific types: financial, operational, combined and operating.

Here’s a summary of the different types:

Positive leverage effect: the return on total capital exceeds the cost of debt, so return on equity increases and the leverage boosts profit
Negative leverage effect: the return on the investment isn’t enough to cover debt interest, which reduces return on equity
Neutral leverage effect: the return on capital matches the cost of debt, so borrowing offers neither an advantage nor a disadvantage

In addition to the basic categories, there are specific types of leverage that are relevant depending on the application:

Financial leverage: relates to using debt to increase return on equity
Operational leverage: describes the proportion of fixed costs in a company’s total costs
Combined leverage: links financial and operational leverage to amplify the effect
Operating leverage: shows how strongly changes in revenue affect operating profit (EBIT)

Terms you should know about the leverage effect

To better understand the leverage effect, it’s useful to know a few key financial terms. These help you grasp the mechanisms behind leverage and make well-founded decisions. Return on equity, return on total capital and return on debt are especially important, as they show how profitable an investment or company is. The debt ratio also indicates how much debt is used compared to equity – a key figure in understanding the impact of leverage.

Return on equity

Return on equity shows how much return is generated from the equity invested. It's expressed as a percentage and reflects how efficiently a company or investment uses its own funds. Here’s the formula:

Return on equity (%) = (Profit / Equity) × 100

The higher the return on equity, the more profitably the company uses its capital. A positive leverage effect can raise this figure by using debt profitably.

Return on total capital

Return on total capital measures the return on all capital employed – the interest earned on both equity and debt. It shows how efficiently a company uses the capital available to it. The formula is:

Return on total capital (%) = ((Profit + Interest on debt) / Total capital) × 100

This is a crucial figure for the leverage effect, as it must be above or below the debt interest rate to create a positive or negative leverage.

Return on debt

Return on debt shows the return that debt achieves in an investment or business. It’s especially relevant for lenders and investors, as it shows how well a company pays interest on its debt. The formula is:

Return on debt (%) = (Interest / Debt) × 100

If the return on total capital is higher than the return on debt, a positive leverage effect arises, as the debt is being used efficiently.

Debt ratio

The debt ratio shows the proportion of debt to equity and indicates how highly leveraged a company or investment is. This is the formula:

Debt ratio = Debt / Equity

A high debt ratio means a lot of debt is being used, which can amplify the leverage effect. However, the risk also increases if the investment doesn’t deliver the expected return.

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How does the leverage effect work?

Simply put, the leverage effect occurs when companies or investors use debt capital to increase their return on equity. They raise funds either from their own resources or through loans and invest in high-yield projects. The key question is whether the investment generates a higher return on total capital (Return on Investment, or ROI) than the interest charged on the debt. If the investment return exceeds the cost of debt, the return on equity rises – the effect is positive. However, if the return on total capital is lower than the cost of debt, using debt reduces return on equity, resulting in a negative leverage effect. The more debt is used relative to equity, the stronger the leverage – with the potential for higher profits but also greater risk.

Here’s how the mechanism of the leverage effect works step by step:

Build capital structure: A company or investor uses equity and may also raise debt, e.g. through a loan
Make an investment: The total capital is invested in a project or asset expected to generate a return
Compare total return and cost of debt: The key is whether the investment return is higher or lower than the interest paid on the borrowed funds
Leverage impact on return on equity: If the return on capital exceeds the debt interest rate, return on equity rises and the leverage effect is positive. If it falls below, return on equity declines, causing a negative leverage effect
Debt ratio influences the effect: The more debt is used compared to equity, the stronger the leverage effect – both positively and negatively. A high debt ratio can boost profits but also increases risk

Formula for calculating the leverage effect

The leverage effect calculation shows whether using debt improves or worsens return on equity. You can use the following formula:

Return on equity = Return on total capital + (Return on total capital – Cost of debt) × (Debt / Equity)

Return on total capital reflects the return on all capital used, while the cost of debt refers to the interest rate paid. "Debt / Equity" represents the ratio of liabilities to equity. If the return on total capital is greater than the cost of debt, the effect is positive – otherwise it's negative.

Examples: Different scenarios in the leverage effect

The leverage effect impacts return on equity depending on how the relationship between return on capital and cost of debt evolves. Let’s explore three scenarios with different capital structures and levels of debt.

Scenario 1: Equity-only financing

A company invests €2,000,000 entirely from equity and earns a profit of €100,000. The return on equity is:

€100,000 / €2,000,000 × 100 = 5%

As no debt is used, return on equity equals return on total capital at 5%.

Scenario 2: Equity and debt financing (positive leverage effect)

The company still invests €2,000,000, but now uses €1,000,000 as debt at an interest rate of 3%. Debt costs are:

€1,000,000 × 3% = €30,000

With profit before interest remaining at €100,000, the post-interest profit is €70,000. Equity is now €1,000,000:

€70,000 / €1,000,000 × 100 = 7%

As return on total capital (5%) exceeds the cost of debt (3%), the leverage effect is positive, and return on equity rises to 7%.

Scenario 3: High debt ratio (negative leverage effect)

Now the company uses only €500,000 in equity and borrows €1,500,000. Due to the higher debt ratio, the interest rate increases to 6%. Debt costs are:

€1,500,000 × 6% = €90,000

After subtracting the interest from the original €100,000 profit, only €10,000 remains. Return on equity:

€10,000 / €500,000 × 100 = 2%

As the cost of debt (6%) exceeds return on capital (5%), the leverage effect turns negative and return on equity drops.

Application in crypto trading

The leverage effect also applies in crypto trading but with higher risks. A trader uses 5x leverage to open a larger Bitcoin position. With a 10% price increase, the trader gains 50% on their equity. But if Bitcoin falls 10%, they lose 50% – a classic example of leverage amplifying both profits and losses.

Pros and cons of the leverage effect

The leverage effect offers both opportunities and risks. While it can increase return on equity and enable larger investments, it also raises the risk of financial losses.

Advantages of the leverage effect

Higher return potential: Using debt can increase return on equity if the investment is profitable
Expanded investment opportunities: Leverage allows companies and investors to undertake larger investments than equity alone would permit
Capital efficiency: Companies can use their equity more strategically while benefiting from low interest rates
Flexibility in financial strategy: Leverage enables faster investment decisions and accelerates growth
Hedging options: In some scenarios, leverage can act as a strategy to manage risk

Disadvantages of the leverage effect

Greater loss risk: Leverage amplifies losses as well as gains if the investment underperforms
Interest costs as a burden: Debt isn’t free, and rising interest rates can hurt profitability
Increased insolvency risk: High debt levels can lead to financial trouble if returns don’t cover costs
Complexity and planning: Leverage requires a precise financial strategy and accurate risk calculations
Additional costs: Besides interest, there may be transaction fees, margin requirements or collateral obligations

What’s the difference between regular leverage trading and Bitpanda Leverage?

In regular leverage trading, investors use debt to open larger market positions, with real cryptocurrencies or securities as underlying assets. Profits can be leveraged, but losses may also exceed the invested capital.

Bitpanda Leverage works differently – you don’t trade real cryptocurrencies. Instead, positions are based on Contracts for Difference (CFDs) that simply mirror the price movement of an asset. The main benefit: with a margin close-out control, a position is automatically closed once a 50% loss on the invested amount is reached. A negative balance protection also ensures that you can never lose more than you invested. Bitpanda Leverage allows long and short positions with x1 or x2 leverage, letting you bet on rising or falling prices without owning the cryptocurrency.

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Conclusion: What to keep in mind with the leverage effect

The leverage effect can boost return on equity and enable larger investments, but it also comes with significant risks. Anyone using leverage should closely monitor the return on total capital, the cost of debt and the debt ratio.

In leverage trading, both gains and losses are magnified, so effective risk management is essential. Especially in the crypto market, which is highly volatile, misusing leverage can quickly lead to heavy losses.

Whether you're dealing with traditional leveraged investments or Bitpanda Leverage, one rule applies: a well-informed trading strategy and a clear understanding of how leverage works are vital to benefit from it without taking on uncontrolled risks.

Frequently asked questions about the leverage effect

Here are answers to the most common questions about leverage.

When is the leverage effect used?

The leverage effect is used when companies or investors want to boost return on equity using debt. It’s common in corporate finance, real estate and leverage trading. Leverage can help finance growth or increase investment capacity.

When does the leverage effect take effect?

The leverage effect kicks in when return on total capital is higher than the cost of debt. In this case, return on equity increases and the effect is positive. If the return is lower than the cost of debt, the effect turns negative and reduces profitability.

How can you calculate the leverage effect?

You can calculate the leverage effect using this simple formula:

Return on equity = Return on total capital + (Return on total capital – Cost of debt) × Debt ratio

The difference between return on total capital and the cost of debt shows whether the effect is positive or negative. A high debt ratio amplifies leverage in both directions.

When is the leverage effect worthwhile?

The leverage effect is worthwhile when the return on capital exceeds the cost of debt, increasing return on equity. This is often the case when companies or investors can borrow at low interest rates and expect high returns. But if the risk is too high or borrowing costs are steep, the leverage effect can become a drawback.