What is Financial Leverage, and How is it Calculated?

Although most people need to be more explicit about financial Leverage, the truth is that it can be a great tool to improve your economic situation. Mainly because it is an investment formula that eliminates risks and that almost everyone has used at some point without being aware of it, with something as familiar as buying a house through a mortgage. 

However, more than contributing own capital and credit is needed to speak of Financial Leverage. The goal is for that investment to pay off over time.

What is Leverage?

But what exactly is financial Leverage? Although semantically, it can lead to error, this term is related to an economical operation’s lever, unlocking, or impulse. Specifically, it refers to investments that use part of their own capital and debt to obtain a return. 

Continuing with the previous example, when acquiring a home with a mortgage, a bank or financial institution shares the initial contribution, always bearing in mind that the house may appreciate in value over time.

In this sense, we would only speak of financial Leverage when there is an expected return. Buying a second home to rent or sell for more money in a few years would fall within this concept. And precisely, the same thing happens in the business world: we talk about financial Leverage when we refer to operations that exclusively seek profitability. 

And that is the main difference it has concerning the concept of credit: the ultimate goal of financial Leverage is to obtain a return on those borrowed funds. That is to say, it is intended to receive money due to capital that it does not have. A loan does not necessarily seek to get a return on that loan.

What are the advantages and disadvantages?

This formula is designed to achieve a return with capital that we do not have and thus minimize the risks inherent in an investment. 

However, it is an approach that implies that we will start in the negative when it comes to distributing the possible benefits of the investment due to the debt contracted and the interest generated as a result. In this sense, there are several advantages and disadvantages when opting for financial Leverage in a company.

Advantage

• You can contribute less than 100% of your own capital.
• This is a joint venture operation.
• Allows borrowing to save crisis situations.

Drawbacks

• It generates interest that must be paid regardless of how the operation turns out.
• There is a possibility of incurring losses.
• It is a very high-risk operation that can lead to insolvency.

How is financial Leverage calculated?

To calculate the degree of financial Leverage, fractions are used, whose divisor (the last number) represents the value of the investment divided by the own resources invested in the operation, as explained in this post by Banco Santander. 

Imagine, for example, that a company intends to invest 50,000 euros with only 5,000 euros of equity. The resulting fraction would be 1:50,000/5,000, that is, 1:10. This value represents the financial leverage ratio, which means that one of every 10 euros invested comes from the company’s cash.

How can financial Leverage help my business?

This is a beneficial formula for companies with a shortage of their own funds but with the capacity to obtain credit to make an investment. 

The goal is always to get long-term profitability. Hence, numerous companies buy and sell real estate without giving it their own use. It also allows them to invest in other types of assets, in the stock market, or in purchasing shares of another company.

For example, let’s consider a company with €200,000 of its own initial capital that it wants to invest. You could allocate it all to an office worth precisely that price, and that, after five years, will allow you to achieve a return of 20%, that is, 40,000 euros, because its sales value has skyrocketed to 240,000 euros.

Triple profits?

With the financial leverage formula, you could allocate the initial amount (200,000 euros) to buy the entire office building for one million euros. 

If the increase in the value of the property were identical to the previous example (20%), and with an interest rate of 10% for the 800,000 euros lent, that same company could achieve a profit of 120,000 euros five years later: it would be sold the property for 1.2 million, and it would be necessary to subtract the 200,000 euros of initial investment, the 800,000 of the credit and 80,000 for the interests. Using financial Leverage would triple the benefits by investing the same amount.

For all these reasons, financial Leverage is a practical solution for those companies that cannot afford significant investments or want to assume only some of the risk. The key is that the partial indebtedness of an operation serves to unblock it. 

However, borrowing will also multiply the chance of not obtaining profits since for an investment of this type to be profitable, it is necessary to repay the debt and the interest it generates. Therefore, the expected return must always be greater than the interest rate of the loan used.