HomeNEWSWhat is financial leverage and how does it work?

What is financial leverage and how does it work?

Financial leverage can be a great resource for you if used correctly. The purpose of leverage is to give you a higher and faster profit on an investment, making it possible to considerably increase your equity in a short time.

But of course if the profits increase, the risks will also be greater. Therefore, before taking financial leverage, it is good to analyze it carefully and make sure you know what you are doing.

What this article covers:

What is financial leverage in the financial market?

Financial leverage is basically a technique you can use to increase your profits. Using this resource, it is possible to earn a good amount of money, even with little investment.

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Let’s assume that you have analyzed and come to the conclusion that a certain operation will work. You can borrow an amount of money and pay it back within a certain period.

If the operation really works out, you will pay back the loan with a portion of your profit. But there is also the option of the operation failing, and thus you will have a loss, which is why financial leverage is a resource that must be used carefully. Novice investors should not risk operations like this.

What are the benefits of financial leverage?

The biggest advantage that financial leverage brings is the chance to boost your earnings in a short time, even if you have little money. But for that you need to have something to use as collateral, like assets in companies.

Like any type of investment, financial leverage also has its risks. It is important to be aware that there is no magic operation that will give you a lot of profit.

Therefore, before carrying out a leveraged operation, it is important that you know your starting point and the investment risk. From there, you can draw a conclusion whether or not that investment is worth it.

Even if you believe that such an investment is a good opportunity, don’t invest everything you have. A good investor is the one who manages to succeed in several operations, not the one who risks everything and tries his luck in just one.

How does financial leverage work on the stock exchange?

To make the financial leverage you will request the option to buy or sell overdraft in your finance company. You must have something to use as collateral, whether money or assets, this serves to cover possible losses.

As each investment has a chance of risk, the number of times you can multiply your shares will depend on the risk.

How to calculate the financial leverage ratio?

The financial leverage ratios serve to verify whether or not the debt of a given company is under control. There is more than one way to calculate the ratio, but the most used is net debt divided by EBITDA.

How to calculate the financial leverage ratio

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EBITDA is a financial indicator that in English is “Earnings before interest, taxes, depreciation and amortization”, which in free translation means: “Earnings before interest, taxes, depreciation and amortization”. And so, this indicator is fundamental to calculate the financial leverage ratio.

To do this, just take all the company’s debt (with the exception of cash) and divide by EBITDA?? That is, the higher the number obtained in the calculation, the greater the company’s leverage.

What is the financial leverage multiplier?

The leverage multiplier is mostly used for selling or buying short. Each investment has a different multiplier, which is defined by the broker after calculating the risks of the operation.

Let’s say that the broker has allowed a leverage of 40 times, you can multiply up to 40 times the amount you left as collateral.

Now that you know what financial leverage is and how to do it, carefully analyze the available investments and decide whether or not it is advantageous for you to do so.

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