The leverage effect is like using a lever in physics, only in the world of finance. It allows a company or investor to increase the potential profit from an investment by using borrowed funds (debt). Simply put, you borrow money to invest more than you have your own funds.
Imagine you have $100,000. You can invest it and get, say, 10% profit, that is, $10,000.
Now imagine that you borrow another $100,000 at 5% per annum. You now have $200,000 to invest. If you get 10% profit again, you will earn $20,000. But don’t forget that you have to pay back the debt and pay interest. In the end, your net profit will be $15,000.
Increased profit: As you can see from the example, using borrowed funds allowed you to increase your profit from $10,000 to $15,000, while your own investment remained the same.
Increased return on equity (ROE): ROE shows how effectively a company uses its own funds to generate profit. Leverage can significantly increase this figure.
But there is also a downside:
Increased risk: If the investment turns out to be unsuccessful and brings a loss, you will still have to pay back the debt and pay interest. In the worst case, you can lose not only profit, but also some of your own funds.
Financial dependence: A company that actively uses borrowed funds becomes more dependent on creditors. Rising interest rates or a worsening economic situation can lead to serious financial problems.
Bankruptcy risk: If a company cannot service its debt, it may go bankrupt.
Financial leverage can be a powerful tool for accelerating capital growth, but it also carries significant risks. Therefore, it is important to understand when it is justified and when it is better to refrain from using it.
High return potential: If you are confident that the investment will return a high return, exceeding the cost of borrowing (interest rate), then using leverage can significantly increase your profit. For example, if you expect a stock to grow by 20% and the interest rate on the loan is 10%, then using leverage will allow you to make a higher profit than if you invested only your own funds.
Limited equity: When you do not have enough equity to take advantage of a promising investment opportunity, financial leverage may be the only way to take advantage of it.
Portfolio diversification: Using leverage can allow you to diversify your investment portfolio by investing in more assets than if you used only your own funds.
Tax advantages: In some cases, interest payments on loans can be tax deductible, which reduces your overall tax burden.
High market volatility: If the market is highly volatile and unpredictable, using leverage can lead to significant losses, especially if the investment does not go as planned.
Low investment returns: If the expected return on the investment does not exceed the cost of borrowed funds, using leverage will lead to losses.
Lack of financial literacy: If you do not understand how financial leverage works and do not know how to assess risks, it is better to refrain from using it.
Unstable financial situation: If you have an unstable income or large debts, using leverage can worsen your financial situation in the event of an unsuccessful investment.
Insufficient diversification: Using leverage to invest in one asset or a small group of assets significantly increases the risk of capital loss.
You should only use leverage if you are confident in the profitability of the investment and are able to manage the risks. It is important to carefully assess your financial capabilities and not take on too much debt.
Risk assessment: Carefully assess all potential risks associated with the investment and the use of leverage.
Interest rate: Compare interest rates on different loan products and choose the most favorable option.
Loan term: Determine the optimal loan term, taking into account your financial capabilities and the expected return on investment.
Loan amount: Do not take out a loan that you will not be able to repay if the investment fails.
Liquidity: Make sure you have enough liquid assets to cover potential losses.
Financial leverage is a powerful tool that can either increase your profits or lead to significant losses. Its use requires careful analysis, risk assessment and understanding of how it works. Before using financial leverage, make sure that you have sufficient financial literacy, a stable financial position and are confident in the high return on investment. Otherwise, it is better to refrain from using it and invest only your own funds. It should be used wisely, carefully weighing the pros and cons. Remember that the higher the potential profit, the higher the risk of losses.
Financial leverage is like a scale showing the ratio between your and borrowed money in a business. It helps to understand whether loans will benefit the business or create problems.
This indicator is related to how effectively you use all resources and your own investments. The better you manage money, the more profitable the loan can be.
It is advisable to calculate the effect of financial leverage when you want to grow or expand. If the company is temporarily out of money, you can take out a loan, but remember: the business must be profitable. Otherwise, it leads to bankruptcy.
To calculate this, you need to know 3 things: how taxes affect income, how much more profitable the business is than the cost of the loan, and how much borrowed money you have in relation to your own. There is a formula for each of these points.
There is no "correct" value for the financial leverage effect. It all depends on what you do, how the business is structured, what stage of development it is at, and how quickly it is growing. Each company must find its own balance between the benefits and risks of using loans.
Financial leverage is a tool that can help you grow faster, but it must be used carefully. Always evaluate your capabilities and risks.
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