Assets on a balance sheet must be funded by something. In some cases, the safest funding source is shareholders’ equity, or net worth. This is money you own. Other sources of funding include debt (for instance, taking out a mortgage on a house allows you to the fund the purchase price with the bank’s money), funds you hold but don’t own (such as an insurance company that gets to invest the money it receives from policyholders even though it only gets to keep it until it’s time to pay out as policies come due (cars wrecked, property destroyed, etc.)
Take someone who owns an asset – say a fine painting - that costs $100,000. If they fund the entire purchase with shareholders’ equity, or net worth, and the work of art increases in value 10%, then they pocket $10,000. Likewise, if it falls 10%, they lose the same amount. If, however, they funded the purchase price 50% with equity and 50% debt, that same increase would cause double the gain or loss in percentage terms less the cost of the borrowed funds. If it took a year to sell the painting at a gain (let’s ignore taxes for now) and the interest rate was 8%, then the percentage increase would be 18.4% ($10,000 gain - $800 interest = $9,200 net gain divided into $50,000 equity = .184, or 18.4%). The loss would be 21.6% ($10,000 loss + $800 interest cost = $10,800 total loss - $50,000 equity = $39,200 net funds = 21.6% loss).
This very mathematical relationship is what makes leverage so effective on the positive side and so destructive on the negative side. The process of deleveraging is designed to reduce the total amplifying effect of volatility. Although it sometimes means giving up the potential of upside gains, it takes away a lot of the risk so the focus can be on fixing the underlying business or catching your financial breath.
