“Leverage” is a term that is used a lot to describe companies and financial transactions. Depending on the topic, being leveraged seems to mean both a good thing and bad thing. But what is leverage in finance and how wary should you be if it’s used to describe an investment?

“Leverage can be a lucrative strategy, but there is a good amount of risk involved,” Richard Cayne of Meyer International says. “It allows for greater opportunity, but success depends on many other factors.”

Leverage is basically debt

Leverage is, in fact, debt. But not any debt. Leverage typically describes debt incurred for expanding a business, for financing assets, or for investment. When this debt surpasses equity, that’s when “highly leveraged” comes into use.

It could be a semantic trick – saying that you’re in a lot of debt doesn’t instill a lot of confidence when it comes to most investors. However, there is a positive aspect to “leverage” that “debt” doesn’t convey. Think of an actual lever. It helps you lift or move items that you probably couldn’t easily budge on your own. Financial leverage allows a person or entity to enter into transactions they would normally not be able to afford.

Leverage can pay huge or backfire spectacularly

By counting on borrowed capital for funding, if the transaction fails, the losses can be greater than a company can handle. Leveraged buyouts (LBOs) are good examples. Buyers embarking on LBOs usually borrow around 90% or more of the purchase price. With that extremely high ratio of debt, investors must be willing to take on great risk. Silver Lake risked 85% in leverage to acquire the computer company Dell. After extreme cuts and restructuring, its $2.4 billion investment in 2013 grew to around $6 billion in 2019. Conversely, the group of private equity firms that raised $45 billion to buy the energy company TXU never saw any returns as the company went bankrupt seven years later.

Pay attention to leverage

There are many stories of boom and bust in the LBO world, which should be taken as object lessons in being too highly leveraged. Even the most savvy and experienced dealmakers can miscalculate and lose. Whether it’s in your own finances or in the financial health of your investments, you should understand the risks involved with leverage on any level.