Leverage is a financial strategy associated with the way of financing and spending. As in physics, a “lever” is used to more easily accomplish what would otherwise require more effort. In the financial field, it is easier to achieve higher profits or boost profits.
Financial leverage is an investment mechanism based on indebtedness, that is, it is the method used by many companies when investing in a business: they contribute part of their own capital and the other part, through loans acquired from third parties. These types of strategies can be beneficial if everything goes as expected, however the risk involved can be much higher.
The basic element within what financial leverage means is debt, since it allows the investment of more money than you actually have, thanks to what you obtain from the loans, in exchange for interest. One of the purposes of this method is to be able to increase the profits of the company, using borrowed funds.
Basically, through financial leverage, we manage to invest more money than we really have and thus obtain more profits (but also greater losses) than if we had invested only our available capital. A leveraged operation (whether by debt or another financial instrument) has a higher return with respect to the capital that we have invested. The lower the capital invested, the greater the financial leverage. It is worth clarifying that a high degree of financial leverage entails high interest payments on that debt, negatively affecting profits.
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TYPES OF FINANCIAL LEVERAGE
Within the concept of leverage, we can find different types of leverage in the economy:
- The positive: This type of leverage arises when the profitability derived from the operation turns out to be greater than the amount of interest and commissions paid for the credit.
- Neutral: Neutral leverage is obtained when the return achieved is equal to or similar to the interest on the capital left.
- Negative: This classification appears when the return is lower than the interest paid for the borrowed liquid.
ADVANTAGES OF FINANCIAL LEVERAGE
The use of leverage can favor us in the following cases:
- Indebtedness helps to increase the profitability to be obtained. It can cause a multiplier effect on the benefit.
- Leverage can help to invest on certain operations or assets that, due to their high value, would limit our access to investment.
- Positive financial leverage is benefited by stages of inflation.
DISADVANTAGES AND RISKS OF FINANCIAL LEVERAGE
Financial Leverage can have the following disadvantages:
- In the event that an investment that is financed through external resources produces losses, the investor may become insolvent.
- The higher the leverage level, the higher the risk level.
- Deflation stages negatively affect financial leverage.
The greatest risk that we can face when using financial leverage is that losses multiply and end up putting our assets at risk. If the evolution of the investment is not what was expected and losses are incurred, to these losses must be added the repayment of the debt incurred together with the corresponding interest.
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