Definition of 'Leverage'
There are two main types of leverage:
* **Financial leverage** is the use of debt to finance an investment. For example, a company may borrow money to build a new factory. The factory will generate income, which can be used to repay the debt and earn a profit.
* **Operational leverage** is the use of fixed costs to generate revenue. For example, a company may own a fleet of trucks that it uses to deliver goods. The trucks represent a fixed cost, but they can be used to generate revenue by delivering goods to customers.
Leverage can be a powerful tool for increasing returns, but it also carries significant risks. If an investment does not generate enough income to cover the cost of debt, the investor may lose money.
Here are some of the key risks associated with leverage:
* **Interest rate risk**. When interest rates rise, the cost of debt increases. This can make it more difficult for an investor to make payments on their debt and earn a profit.
* **Repayment risk**. If an investor is unable to make payments on their debt, they may be forced to sell their investment at a loss.
* **Liquidity risk**. Leveraged investments can be difficult to sell quickly, which can make it difficult for an investor to get out of a bad investment.
Leverage is a powerful tool, but it is important to understand the risks involved before using it. If you are considering using leverage, be sure to speak with a financial advisor to make sure that it is right for you.
In addition to the risks mentioned above, there are also some other things to keep in mind when using leverage. For example, leverage can increase the volatility of an investment. This means that the value of the investment can go up or down more quickly than it would if it were not leveraged.
It is also important to remember that leverage is not free. When you use leverage, you are essentially paying interest on the borrowed money. This can reduce your returns and make it more difficult to make a profit.
Overall, leverage can be a powerful tool, but it is important to understand the risks involved before using it. If you are considering using leverage, be sure to speak with a financial advisor to make sure that it is right for you.
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