What is financial leverage?
Financial leverage basically consists of borrowing to invest, and is generally used by both companies and individuals. The use of this investment system is on the rise among investors.
It works by turning to debt, which allows the user to invest more capital than they have thanks to the capital that they have borrowed. This method makes it possible to make an investment without having all the necessary money available, whilst maximising the profitability of the investment due to having more capital, so if the transaction goes well, the profit grows considerably.
Furthermore, the fact that the financial leverage allows us to invest more capital than we have results in the profit (or loss) derived from the transaction being greater than if we had only used our capital.
This method can be carried out by requesting debt or through financial derivatives. The more debt used, the higher the level of financial leverage. The investor must consider the interest payable for the money borrowed in the leverage transaction, which could negatively affect the profit.
Therefore, the final balance of a financial leverage may be positive -if the transaction generates profit in the investment-, negative -if we incur losses in the invested capital- or neutral -when the return is the same as the invested capital-.
How to calculate financial leverage
To calculate the level of financial leverage, it is normal practice to use fractional units, so if we talk about a leverage of 1:2 we are saying that for every euro of our capital invested, we are actually investing two euros (one own and another borrowed), and therefore the debt also amounts to one euro. There is a formula for calculating the financial leverage of an investment:
Value of the investment
Financial leverage= 1: -------------------------------
Own resources invested
For example, let's imagine that we have invested 2,000 euros of our money but the total value of the investment is 20,000 euros. In this case, we are resorting to debt or derivative products to increase the capital of the transaction. In this case, according to the above formula, the leverage would be 1:10.
Financial leverage of the investment= 1: ---------- = 1:10