Financial leverage: what it is, advantages, disadvantages and examples

Financial leverage is an instrument that is used to try to achieve greater profitability in certain investment operations, but it also carries a risk. In this article we explain what it consists of and give you some examples to understand it better.

What is leverage?

Financial leverage consists of resorting to some mechanism that allows increasing the amount of money that can be allocated to an investment .

It is so called because it is used as a lever, making said investment more profitable.

What is leverage used for in trading?

Through financial leverage, more money can be invested than what is actually available .

In this way, you could get to have greater benefits than if you had only invested the capital that was previously available, although the losses in the operation may also increase.

Advantages and disadvantages of leverage

The biggest advantage of financial leverage is that if the operation goes well, profitability increases . In that case, with the amount earned, the credit can be returned and still have profits.

But the risk is evident: if the investment does not work out, you can have many problems when it comes to paying off the debt , and even fall into a situation of insolvency.

Leverage on earnings

Profitability changes when you decide to opt for financial leverage.

Let's give an example: we request a loan from our bank for half of what a home is worth, 150,000 euros with 10% interest. After a while, the property has a value of 400,000 euros, and we put it up for sale.

First of all, we must remove the amount of the credit , interest included, from the amount obtained when selling the house:

400,000 – 165,000 = 235,000 euros

Now we subtract the part of the house that we paid for with our own savings , which was half its price:

235,000 – 150,000 = 85,000 euros

We have 85,000 euros left, which is the profitability that we have achieved with this operation.

Leverage at losses

Now let's say that the house is devalued, for example as a result of a natural catastrophe, and its value remains at 200,000 euros.

By subtracting the 150,000 euros that we invested in it from our own savings, and the 165,000 euros of the credit with its interests, it turns out that we have a loss of 115,000 euros.

How to Calculate Financial Leverage: Collateral Ratio

When calculating the level of indebtedness involved in an operation, the financial leverage ratio is used, which consists of dividing the total capital invested by its own capital .

The leverage ratio can also be expressed through the percentage of own funds contributed , in which case it will always be greater than 100% (because 100% of the investment is our own capital).

Examples of financial leverage

To better clarify what we have seen so far, let's give an example. We want to make an investment for which we have a capital of 20,000 euros, and we would like to obtain a return of 12%.

By investing our 20,000 euros, we would be able to earn 2,400 euros. Now, if we want to invest 120,000 euros, our earnings would be 14,400 euros. In that case we have to request a credit of 100,000 euros.

Another option is to contact an intermediary and leave our 20,000 euros as a guarantee. Through the broker we opened an operation for a total of 100,000 euros, so our leverage is 500%.

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