Have you ever heard the saying, “It takes money to make money?”
Luckily, it doesn’t necessarily have to be your own money.
‘Financial leverage’ is one-way investors can use other people’s money to increase their returns. It can be a powerful tool for investors but can also amplify risks and lead to significant losses.
In this guide, we will explore everything you need to know about financial leverage, including how it works, the risks and benefits, and how it can impact return on investment.
What is Financial Leverage, and How Does it Work?
Financial leverage is a concept in finance that refers to using borrowed funds to increase the potential returns of an investment.
For example, suppose an investor wants to buy a property worth $500,000 but only has $100,000 in cash. They could use financial leverage to borrow the remaining $400,000 from a bank or other lender. If the property appreciates by 10%, the investor’s return on their $100,000 investment would be 50% ($50,000) instead of just 10% ($10,000) without the leverage.
However, financial leverage also increases the risk of losses. If the property’s value declines by 10%, the investor will lose $50,000 instead of just $10,000 without leverage. This is because they would still owe the full loan even though the property’s value has declined.
Thus, it’s essential for investors to understand the risks and rewards of financial leverage and to use it judiciously in their investment strategies.
Calculating the Degree of Financial Leverage
Be it an individual investor or a company trying to maximize its profit, there are two commonly used formulas for assessing the level of financial leverage one has — Debt-to-Equity ratio and the Consumer Leverage ratio.
These financial ratios are commonly called leverage ratios.
1. Debt-to-Equity Ratio
The Debt-to-Equity (D/E) Ratio is calculated by dividing the total debt an individual, or a company owes by their total equity. Equity refers to savings, investments, and property minus liabilities, such as outstanding loans or mortgages.
The formula is:
Debt-to-Equity Ratio = Total Debt / Total Equity
For example, if a company has $500,000 in total debt and $1,000,000 in total equity, the debt-to-equity ratio would be 0.5 ($500,000 / $1,000,000). This means that for every $1 of equity, the company has $0.50 of debt.
2. Consumer Leverage Ratio
Just as companies use leverage for their operations, households can also use it by taking on debt and using personal income to pay interest charges.
Consumer leverage is a metric that measures the debt level relative to a household’s disposable income.
The formula is:
Consumer Leverage Ratio = Total Household Debt / Disposable Income
A high consumer leverage ratio indicates that a household has a large amount of debt compared to its income, making them highly leveraged. When consumer leverage gets too high, households may struggle to secure additional loans, such as mortgages, as lenders typically impose debt-to-income limitations.
Both formulas can assess one’s financial leverage and ability to repay debts.
Understanding the Impact of Financial Leverage on Investments
Financial leverage can significantly impact investments. When investors use leverage to invest in a financial asset, they borrow money to increase their investment size. This can amplify the returns that the investor earns, but it can also amplify the losses.
For example, let’s say an investor has $10,000 to invest in a stock that they believe will increase in value.
1. Without Financial Leverage
- Borrowed Fund = None
- Purchase value of stock = $10,000
- Profit (if the stock value increases by 10%) = $1,000
- Loss (if the stock value decreases by 10%) = – $1,000
2. With Financial Leverage
- Borrowed Fund = $10,000
- Purchase value of stock = $20,000
- Profit (if the stock value increases by 10%) = $2,000
- Loss (if the stock value decreases by 10%) = – $2,000
Also, the cost of borrowing is an important factor to consider when using financial leverage. In the example above, if the interest rate on the borrowed funds is 10%, the investor would need to earn at least 10% on their investment just to break even. If the interest rate is higher, the investor would need to earn even more to cover the cost of borrowing.
This example illustrates the benefits and risks of using financial leverage in investments.
While leverage can increase potential profits, it can also increase potential losses and amplify the overall risk of the investment. It’s important for investors to carefully consider the risks and benefits of using leverage before making any investment decisions.
Benefits of Financial Leverage
Financial leverage can offer several benefits, depending on its use.
1. Amplified Returns
One of the most significant benefits of financial leverage is that it allows investors to amplify their returns. This is because leverage enables investors to control larger positions than they would be able to with just their own capital.
If the investment performs well, the investor can earn much more than they would have without leverage.
2. Diversification
Financial leverage allows investors to diversify their portfolios more easily. Investors can spread their capital across multiple investments by borrowing money to invest.
3. Increased Liquidity
Using leverage can also increase an investor’s liquidity by freeing up capital they can use elsewhere.
Limitations of Financial Leverage
There are limitations to using financial leverage as well.
1. Increased Risk
One of the most significant limitations of financial leverage is that it increases the overall risk of an investment. As discussed earlier, leveraging amplifies gains and losses, so the losses can be substantial if the investment doesn’t perform well.
2. Interest Costs
When investors borrow money to invest, they will have to pay interest on that loan. This can increase the cost of the investment and eat into potential returns.
3. Potential for Margin Calls
Margin calls occur when an investor borrows money from a broker to buy securities, and the value of those securities decreases significantly.
In this situation, the investor may receive a margin call from the broker, which requires the investor to deposit additional funds or securities to cover the loss. If the investor fails to do so, the broker may sell some or all of the securities in the investor’s account to recover the borrowed funds, potentially causing the investor to incur further losses.
Thus, investors using leverage can experience margin calls when an investment declines in value.
Conclusion
Financial leverage can be a powerful tool for investors looking to increase their returns using other people’s money. But, it’s important to understand the risks and limitations of using leverage, as it can amplify losses and lead to significant risks.
By understanding how leverage works, calculating the degree of leverage used in an investment, and carefully managing risk, investors can use financial leverage to their advantage.
Ultimately, the key to success with financial leverage lies in balancing risk and reward and making informed investment decisions. With the right approach, financial leverage can be a valuable addition to an investor’s toolkit, helping them achieve their financial goals and build long-term wealth.
FAQs
1. What is financial leverage, and how does it work?
Financial leverage refers to using borrowed funds to invest, aiming to increase potential returns. It involves borrowing capital at a relatively low-interest rate and investing in assets with the potential for higher returns.
The goal is to earn a higher return than the cost of borrowing.
2. How can financial leverage impact return on investment (ROI)?
Financial leverage can significantly impact ROI, allowing investors to control larger positions than they could with just their own capital.
This amplifies both gains and losses, so it is important to carefully consider the potential risks before using leverage.
3. How can financial leverage be used in asset allocation and margin trading?
Financial leverage can be used in asset allocation to diversify a portfolio and earn higher returns.
In margin trading, investors use leverage to trade securities, amplifying potential returns and increasing the risk of losses. Using leverage carefully in both cases is important, as it can increase risk and potential rewards.
