Financial leverage: what is it and what can it be applied to?

Knowing what leasing is and obtaining financing are some important steps for those who want to meet objectives such as achieving their financial freedom. In this scenario, financial leverage is one way to obtain it, which can be very useful in certain cases.

Now, what does this instrument consist of and when can it be useful? Below, we will explain how you can manage it.

What is financial leverage and in what situations can it be useful?

This term refers to the mechanism that allows you to increase the amount of money used for an investment. For this reason, it is said to be the relationship between one's own capital and the capital actually used for a financial operation.

The concept comes from "to lever". That is, thanks to a supporting technique, such as debt, more money can be invested than one possesses. If this goes well, it is possible to achieve more positive results than if such a mechanism had not been used.

So, in what can financial leverage be applied? These are some options:

• Investment in a business. For example, you could need to leverage yourself to open your business and make it grow quickly. In this case, you would obtain greater capital than what you possibly have with just your savings.
• Increased profitability. If you are confident of a certain investment, you could take on debt to make it and increase profitability. In other words, earn more money.
• Investment in assets. You can also invest in assets without needing to have your own capital. For example, many people often implement it in cryptocurrencies.

How does financial leverage work?

This mechanism is measurable. For example, a 1:3 leverage implies that, for every thousand pesos of one's own money invested, three thousand pesos in total are invested. That is, there would be two thousand pesos of debt, which implies that one's own capital corresponds to 33% of the investment. The formula is simple: one (1) is divided by the value of the investment.

For example, imagine that a company is trading at $1,000 per share and you have $10,000,000 saved, so you buy 10,000 shares. If, after some time, the shares are trading at $1,500 and you sell them, you will obtain a 50% return. To increase your return, you could leverage yourself and acquire 100,000 shares. This implies that you need a loan of $90,000,000. By selling them, you will be able to pay the debt with its interest and you will obtain a 400% return.

H3: What should you consider in making this decision?

If you wish to make use of financial leverage, it is advisable to examine the following variables:

• The size of the debt. In other words, how much will you commit your wealth? Think that you will then have to pay the money plus interest.
• Payment terms. How should you amortize the debt? Consider this when making the decision.
• The need to do it. In other words: are you 100% confident that this leverage will be appropriate?

What types of financial leverage exist?

Now that you know the concept, let us see what types of leverage there are. These are defined based on the results obtained. Namely:

• Positive: profitability is higher than what you must pay for credit interest.
• Negative: profitability is lower than the interest paid for the debt.
• Neutral: the return on the investment is very similar to the interest generated by the capital. Therefore, no money is gained or lost.

For this reason, it can be said that the pros occur when the result is positive. There, greater returns can be obtained without needing to have the capital. The con occurs in negative results, that is, when the investment goes wrong. Especially if you cannot pay the debt or you spend more money than you thought. If the result is neutral, there are no pros or cons, beyond having wasted time.

How to know if it is a resource that suits your needs?

Now, to carry out financial leverage, it is necessary to have full confidence in the decision you must make. Thus, leveraging yourself should only be an option if you do not have the capital necessary to make an investment that you trust in and need.

Otherwise, you would unnecessarily expose your wealth, so it is recommended to only use saved money. Therefore, it is necessary to evaluate the risk. That is, to know if you can pay the loan plus interest, in case something goes wrong. In addition, you can analyze how viable the investment is, by consulting with several specialists.

In this sense, financial leverage is not good or bad in itself. In reality, it depends on the characteristics of the project in question and the risk management that the person is willing to assume. Now that you know it, we hope you can use it effectively!

Bibliographic references

Barajas, A., Natalucci, F. (2021, March 29). Facing the dangers of growing leverage. IMF Blog. International Monetary Fund. https://www.imf.org/es/Blogs/Articles/2021/03/29/confronting-the-hazards-of-rising-leverage

European Institute of Postgraduate Studies - IEP (n.d.). Financial leverage: what is it and how is it calculated? https://www.iep.edu.es/apalancamiento-financiero-que-es-y-como-se-calcula/