Talk:Leverage (finance)/Archives/2013

Technical language tag

When I write this, the article opens thus (first sentence skipped):

Leverage exists when an investor achieves the right to a return on a capital base that exceeds the investment which the investor has personally contributed to the entity or instrument achieving a return.[2] Common ways to attain leverage are borrowing money, buying fixed assets and using derivatives.[3] Important examples are:

• A public corporation may leverage its equity by borrowing money. The more it borrows, the less equity capital it needs, so any profits or losses are shared among a smaller base and are proportionately larger as a result.[4]
• A business entity can leverage its revenue by buying fixed assets. This will increase the proportion of fixed, as opposed to variable, costs, meaning that a change in revenue will result in a larger change in operating income.[5][6]
• Hedge funds often leverage their assets by using derivatives. A fund might get any gains or losses on $20 million worth of crude oil by posting $1 million of cash as margin.[7]

A lot of these sentences are very difficult to understand. What does it mean to "leverage equity?" To "achieve the right to a return on a capital base" -- especially when it's the right to a positive or a negative return, a loss. "Entity or instrument" -- this is opaque. What is a "fixed asset?" What does it mean to "leverage revenue" and how is that linked to "operating income?" What does it mean to "post cash as margin?"

I understand that I am not well versed in economics (that is why I tried to look this up), and I also understand that all these terms have clear, specific definitions in economic theory. But the article leader should make it easy to grasp the basic idea, and technical specifics should come later. This leader couches its statement of the basic idea in jargon-y language and then gives examples which are also, quite unnecessarily, in jargon.

Here are some draft improvements. I post this as a draft in the hopes that those who understand the subject better will make it more accurate (but not necessarily more jargonishly precise).

A firm gains leverage when it takes any action that increases the magnitude of return on an investment relative to the amount the firm individually invests, whether that return is a gain or a loss. So if a firm is highly leveraged with respect to a certain investment, and that investment performs well, the return will be higher than it would had the firm been less leveraged, all other things being equal. Conversely, if a firm is highly leveraged with respect to an investment and it performs badly, the return will be lower than if the firm had been less leveraged.

Common ways to get leverage include borrowing money, buying fixed assets, and using derivatives. Examples:

• Suppose a firm borrows money to invest. The proportion of equity capital to borrowed money used for the investment becomes lower. So if the investment's return is sufficient to cover the equity, borrowed money, and interest on the borrowed money (the outlay), then the loan and equity are taken care of and any further return is proportionate to the full amount invested, including money that the firm did not individually invest (i.e. the borrowed money). The gain will thus be greater. However, if the investment's return is not large enough to cover the full outlay, then the amount by which the return falls short will likewise be proportional to the amount invested, and since the loan + interest must still be paid back, the loss taken by the firm will be greater.
• Suppose a firm chooses to acquire an asset for a fixed cost (eg. $1000/month) instead of one that varies in cost proportionately to production (eg. $10 per item produced). If revenues increase this cost will still be fixed, and so the firm will be able to keep a larger proportion of the revenues as income than if there were a variable cost, which would go up as revenues increased (assuming production is tied to revenues). However, if revenues decrease, then a variable cost would likewise decrease, whereas a fixed cost would end up absorbing a larger proportion of revenues and the firm would have to retain a smaller proportion as income.

I'm not sure I know how to rewrite the third one, as I don't really understand it. Please discuss and propose improvements to this suggestion. It seems to me that for people who want to understand what is discussed about finance (which is a lot of people, given what happened a few years ago) that this term in particular is very important to know. It's tossed around frequently in a lot of contexts, and so we can't write this article as if only people into econ will read it. Rainspeaker (talk) 21:54, 2 November 2013 (UTC)