To begin with, the meaning offinancial leverage It is nothing more than borrowing to invest. This concept applies in the business, private and family environment.
It is necessary to be very clear about what financial leverage is, to manage it properly and that the levels of debt do not exceed the finances that we have to cover it.
In this article we will explain how this source of financing for companies works, how they can
What is leverage
Financial leverage consists of using a loan, which is transformed into a leveraged product or borrowed money, with the aim of increasing investment capital or financing an operation.
This is also related to the ability of a company to obtain benefits by optimizing the use of its fixed assets and the financing they receive to achieve profits.
He financial appeceament it allows profitability to multiply, assuming the risk that the operation fails, and the company must go out and look for resources to cover said loan, this being one of the negative effects of leverage.
When we leverage, we establish a relationship between equity and borrowed money, so the higher the debt, the higher our level of leverage.
One of the positive effects is that you can maximize the profitability of a transaction, since you have more capital to work with. So in the event that the operation results in a profitable trade, the profits will grow due to leverage.
What is financial leverage used for?
Financial leverage is perfect for investing much more money than we have, sustaining ourselves on a debt or loan, to expand working operating capital.
In other words, leverage is used to finance the expansion of our operations.
We clarify that using more debt (credit) is having greater financial leverage and therefore would be higher interest payments, directly affecting the profits of a business.
However, companies opt for this resource to get the most out of the investment of other people’s money, aiming to achieve great benefits, although there is a risk of loss if it does not work out.
When is this financing strategy appropriate?
It is a suitable strategy as long as there is knowledge of what is done in the market, apart from a thorough review of how capital is managed and the commitment that this transaction implies.
Knowing how to handle financial leverage is the difference that makes it a good ally or a counterproductive instrument.
So, a good way to use it is with the advice or leadership of advisors with experience in markets and capital management.
Types of financial leverage
There are three types of financial leverage and they depend on the effect that occurs according to the amount of investment.
Positive Financial Leverage (RE > k)
It is that in which the funds obtained from the loans are productive.
It means that the rate of return or Economic Return (RE) on the company’s assets is higher than the interest rate paid for the funds obtained with the debt (k) and commissions.
Its product is Financial Profitability (RF).
Negative Financial Leverage (RE < k)
In this case, the funds obtained from loans are unproductive. It means that the RE is less than the class of interest paid, consequently the increase in debt worsens the RF.
The debt was unproductive, because we paid more for the loan than the rate levels that the company’s assets achieve.
Neutral Financial Leverage (RE = k)
It occurs when the RE equals the interest rate that is canceled and the commissions for the funds that are obtained with the loans.
In the neutral financial leverage, the indebtedness does not generate a variation effect of the RF, which means that the debt is indifferent.
So the goal is to achieve a financial appeceament net positive, so that the debt would generate an increase in financial profitability. Consequently, it is sought that, at least, its effect remains neutral so that greater losses are not incurred.
The logic of positive financial leverage
When a company or business opts for a loan to invest in the acquisition of assets, it does so with the expectation that the return on the loan will be higher than the corresponding amount to pay for the loan.
It must be considered that the costs have to be lower than the profitability for it to be viable to borrow; that is the only way to improve the financial profitability of a business.
If there is the alternative of paying for the assets with a loan from the bank, the conditions of external financing are accepted whenever the amount of the debt (interest rate proposed by the bank) is below the profitability that the acquired assets will yield .
There we are in front of a positive financial leverage.
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Characteristics of financial leverage
Financial leverage tends to be confused with credit, due to its similarities with obtaining financing for a specific objective.
However, it happens that credit is a leverage model. These are the characteristics that distinguish it:
– It uses other people’s money to finance an investment, with a ratio of own capital and debt.
– Profitability is achieved through borrowed funds, which has been the lever.
– Although you work with someone else’s money, the level of use of financing is not totally unlimited.
– Needs constant monitoring of the volume that accumulates due to indebtedness; It also demands the supervision of what is related to assuming new debts, to establish the limits that would entail a risk of insolvency.
– Since we cannot know what the final profitability of the operation will be, all financial leverage implies a high risk. If it turns out well, there will be no problems; otherwise, the effects would be disastrous.
– The investment in leveraged products could cause the contribution to be lost and money that was not budgeted to be spent.
– Suggests working with what you have, never more.
– It is used to enter into some investments that we would not have access to because we do not have sufficient financial means. For example, real estate investments.
– If it is positive, it favors periods of inflation and when it is higher than the amount of the debt, increasing the purchasing power of the company or business.
– The Internal Rate of Return (IRR) can increase with financial leverage. By increasing profitability, so does the IRR that was invested with the loan obtained from third-party resources.
Examples of financial leverage
Although there is a mathematical formula to calculate financial leverage, that is, the measure of the relationship between debt and profitability, the easiest way to understand it is by considering the following hypothetical situations.
Let’s assume that the percentage of debt will be equivalent to 90% of the operation and, just to be an example, we omit the commissions and expenses, to show simply what a transaction with and without Financial Leverage is like, in addition to a negative effect:
Scenario 1: No financial leverage
If we have a capital of about 100 thousand euros and we go for an investment of shares valued at 1 euro each, then we can acquire 100 thousand shares.
As the evolution of the investment is positive, in a given period each one costs 1.5 euros, so we decided to sell. The result would be 150 thousand euros and our benefits are 50 thousand euros, which means 50% of everything invested.
Own capital: 100 thousand
Buy (1 €) = 100 thousand
Sale (€1.5) = 150 thousand
profit = 50 thousand
Scenario 2: With financial leverage
If the own capital is €100,000 and the investment maintains its cost of €1 per share, but we want to take a risk and inject a little more, we request a loan for the amount of €900,000.
Said credit charges us a total interest of 10% and allows the acquisition of 1 million euros of shares.
Assuming that in the same previous period, the shares increase the same (€1.5) and we sell our position, the income obtained is €1.5 million.
The first thing that is done is discount what the credit that was requested evolved (900 thousand euros plus amounts that will be made in 90 thousand euros).
Discounting this subtraction, after selling an income of 510 thousand euros is achieved above the base that was contributed of 100 thousand euros belonging to the own capital. The profitability would be greater than 400%.
Own capital = 100 thousand
Credit at 10% interest = 900 thousand
Buy (1€) = 1 million
Sale (€1.5) = 1 million 500 thousand
Credit Return = 990 thousand
Benefit = 410 thousand
Scenario 3: Negative effect of financial leverage
Considering those same numbers (quite unrealistic and only used to clarify the concepts), let’s review what would happen if the product is negative.
Let’s think that the half point in favor after the investment would be against us, that is, half a point of loss because in the same period the value of the shares dropped to €0.5.
In this case, if financial leverage has not been used, the 100,000 titles could be sold and we would obtain income of 50,000 euros, losing half of the investment.
Now, if we request financial leverage to buy 1 million shares, the result would be only 500 thousand euros from the sale; It means that we will not have enough to respond to the 990,000 euros that represent the sum of the capital and interest on the loan.
The immediate consequence is a debt of 490 thousand euros, almost five times what we invested.
Own capital = 100 thousand
Buy (1€) = 100 thousand
Sale (€0.5) = 50 thousand
Loss = -50 thousand
Own capital = 100 thousand
Credit at 10% interest = 900 thousand
Buy (1€) = 1 million
Sale (€0.5) = 500 thousand
Credit Return = 990 thousand
Loss = -490 thousand
Before taking a financial leverage…
The important thing before deciding on this financial resource is to document and obtain the advice of those who have experience in the area, so that they can tell us when financial leverage is the alternative that will really favor our investment.
It is essential to be vigilant and verify that the interest on the debt is less than the profitability that we obtain; otherwise, the effects would not be as expected.
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