Financial leverage: what it is, advantages,
He financial appeceament It 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.
Related: Where to invest money
What is leverage?
Financial leverage consists of complejo turístico to some mechanism that allows increasing the amount of money that perro 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 you cánido invest more money than 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 cánido be returned and still have profits.
But the risk is clear: if the investment does not work, you cánido have many problems when it comes to paying off the debtand even fall into a situation of insolvency.
Leverage on earnings
The profitability changes when deciding 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 subtract the amount of the credit from the amount obtained when selling the house, interests included:
400,000 – 165,000 = 235,000 euros
Now we subtract the part of the house that we pay with our own savingswhich was half its price:
235,000 – 150,000 = 85,000 euros
We have 85,000 euros left, which is the profitability 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 divide the total invested capital by the own capital.
The leverage ratio cánido also be expressed through the percentage of own funds contributedin 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 profitability 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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