The concept of financial leverage refers to the part of the company that is financed with debt. It allows us to access investments of a certain relevance with minor own funds.
Financial leverage implies greater risk to the company, since external financing represents a cost for the company that has to be reflected in obtaining benefits before deducting interest. This means that in the event that the benefits are abundant with the investments made with external financing, the interests will hardly be noticed, but otherwise they would fall like a slab on the business economy.
The meaning of financial leverage supposes the use of some mechanism, such as debt, to increase the amount of money to be used in the investment. The main means to leverage is debt, which makes it possible to invest more capital than we have thanks to the loans requested.
Objective of financial leverage
With financial leverage it will be possible to invest more money than you have and thus it will also be possible to achieve higher profits or losses than if only the available own funds had been used. A leveraged trade has a higher profitability with respect to the invested capital.
The higher the debt used, the higher the leverage. It must be said that a high degree of financial leverage entails the payment of a higher interest, which will affect profits in a negative way.
Calculate financial leverage
The degree of financial leverage is measured in fractional units. For example, a leverage of 1: 4 means that for every euro invested there is three euros of debt, and equity represents 25% of the investment.
The formula for financial leverage is as follows:
Financial leverage = 1: (Investment value / Invested equity)
Calculate the best level of leverage ratio