What you need to know about financial leverage

Financial leverage is a booming economic term that encompasses the entirety of a person’s finances, as well as their debts. This system focuses on increasing the economic volume as a result of indebtedness.

Financial leverage consists of using debt to finance any operation. In other words, when we are going to carry out an operation, we invest our money, in addition to the amount that we have received through a loan. S and establishes a ratio between equity capital and loan or credit. The end result, if this operation goes well, is the multiplication of profits with excellent profitability.

The main mechanism for leveraging is debt. Debt allows us to invest more money than we have thanks to what we have borrowed. In return, of course, we must pay interest, but not only through debt can financial leverage be achieved.

Financial leverage meaning

Financial leverage is simply using debt to finance an operation . As simple as that. That is, instead of carrying out an operation with own funds, it will be done with own funds and a credit. The main advantage is that profitability can be multiplied and the main drawback is that the operation does not go well and ends up being insolvent.

Let’s take a numerical example that will be clearer. Let’s imagine that we want to carry out a transaction on the stock market, and we spend 1 million euros on shares. After a year the shares are worth 1.5 million euros and we sell them. We have obtained a profitability of 50%.

What happens if we carry out the operation with certain financial leverage? Imagine then that we put 200,000 euros and a bank (or several, in a syndicated loan ) lends us 800,000 euros at an interest rate of 10% per year. After a year the shares are worth 1.5 million euros and we sell. How much have we earned? First, we must pay 80,000 euros of interest. And then we must return the 800,000 euros they loaned us.

That is, we earn 1.5 million minus 880,000 euros minus 200,000 initial euros, total 420,000 euros. Less than before, right? Yes, but in reality our initial capital was 200,000 euros, and we have earned 420,000 euros, that is, 210%. Profitability has multiplied!

Now, there are also risks. Let’s imagine that at the end of the year the shares are not worth 1.5 million euros but 900,000 euros. In the case where there is no leverage we have lost 100,000 euros. In the case with leverage we have lost 100,000 euros and 80,000 euros of interest. Almost double. But with a very important difference.

In the first case we have lost money that was ours, we had 1 million euros that we invested and we lost 10%. In the second case we had 200,000 euros and the bank has to return 880,000 euros of the 900,000 that the shares were worth. We only recovered 20,000 euros. That is, the losses are 90%. Losses also multiply with leverage!

And the worst, let’s imagine that the shares are worth 800,000 euros. Not only would we have lost everything, but we could not afford the payment of 80,000 euros to the bank. We are insolvent. In the case of having the money, we would never have insolvency problems, but now we do.

And these examples that I have put with stocks do not have to be speculative on the stock market, it was to simplify. It can be when buying a company to manage it or carry out an expansion of the company. As long as the investment generates income greater than the interest, we will be in the safe zone, with multiplied returns. But otherwise the problems begin.

Classification of financial leverage.

Financial leverage is used to obtain resources to make investments. That is, we resort to a loan to make an investment, with the intention that this investment gives us a sufficient return to cover the cost of the debt, and we have a profit margin.

Financial leverage can offer three possible outcomes:

• Positive.
• Negative.
• Neutral.

Below we delve into each of them.

Positive financial flattening.

Positive financial leverage occurs when the return on the investment is greater than the cost of the debt incurred.

For example, we make a loan of 10,000 at an annual interest of 10%, paying 1,000 of interest.

With this investment, we bought Ecopetrol shares, which in the year gave us a return of 1,500.

In this case we have had a positive return, since we have earned 1,500 of which we pay 1,000 as a cost of credit, so we will have a positive net return of 500.

Negative financial leverage.

It occurs when the return on investments made with the debt is lower than the cost of the debt.

Continuing with the previous example, if Ecopetrol shares only yield us 800, we are losing 200 because we had to pay 1,000 interest on the loan.

In other words, negative financial leverage occurs when the rate of return on assets is lower than the interest rate paid on liabilities.

Neutral financial leverage.

We have neutral financial leverage when what is earned with the financed investments is equal to what is paid for the liabilities that financed the investments.

Continuing with the example, if we pay 1,000 for the debt and the returns on the shares we buy add up to 1,000, we have a neutral result, where we neither win nor lose, and rather we reach a neutral or equilibrium point.

Advantages and disadvantages of financial leverage

The main advantage of financial leverage is that it multiplies profitability, since own funds are invested , but also third-party capital. So the investment is higher, and therefore, the profitability as well.

Thus, the return on invested equity will be higher the more financial leverage there is, or what is the same, the higher the percentage of money borrowed in that total investment.

It is right at this point where we find the main disadvantage, and that is risk. If the investment is unsuccessful, the debt will be higher the higher the leverage.

That is, even if you do not have benefits, you will still have to pay the debt, plus the interest that it may have generated.

The financial leverage is very common to find on investments in stocks, real estate or business projects.

Conclusion

Financial leverage is simply using debt to finance an investment for for higher returns.

That is, instead of carrying out an operation only with own financing (your money), you will also add the borrowed funds (debt).

The main advantage is that Profitability can be multiplied. The main drawback is that the operation does not go well and ends up being insolvent.

You must assess the relationship between assumed risk and expected return to make your decision before making an investment.

I hope this article has been useful to you and helped you to better understand finances. Kindly leave us a comment and tell us what you think.