Have you recently read in news that a certain bank or a company is highly or massively leveraged? If you don’t know what it means we will try to explain it here.
Every company, bank, or any other financial entity is financing itself from two sources:
1) Own assets or own capital,
2) Borrowed assets, liabilities or credit.
If there are a lot more borrowed assets comparing to own assets, an institution is being highly leveraged. For example, if I have bought a factory for 1 thousand dollars of my money I am not leveraged at all. But if I have bought a factory with 900 dollars of my money and 100 dollars from credit I am leveraged. But if I took a credit of 800 dollars and had only 200 dollars of my money I am being highly leveraged. And if I have to take another credit to invest into new factory equipment, I am being massively leveraged.
Is being leveraged good or bad?
Well, most of the companies, banks and other financial institutions are leveraged to some point. So it is basically a normal behavior. Taking credits stimulates economy, because it encourages investments and economic activity. I am investing in my factory so that I can earn profits in following years, which will enable me to return all credits.
But sometimes we can’t be sure what future brings. There is always a certain risk things won’t go as planned. If my investments doesn’t make me as much profit as I planned, I might go bankrupt. I have to return credit no matter what, and I don’t have enough of my money to cover everything. Going bankrupt means losing not all of my money, but bank’s money as well. That is why if somebody is highly leveraged, banks would refuse to give them more credit.