Many companies use leverage in their daily activities. Although financial leverage (the second name for leverage) offers some benefits to a person or company using this type of financing, there are disadvantages that we will also discuss.
The concept of leverage
What is leverage? This is the use of debt to acquire additional assets or finance projects. In other words, it is the service of a broker who provides funds that exceed his own several times. Using leverage allows you to get much more profit.
Consider the example:
You are a novice investor and have decided that you cannot spend more than $ 100 on stock market transactions. However, you suddenly find a good strategy, but the deal requires $ 10,000. Missing money you borrow from your broker, that is, you get a leverage of 1: 100.
Of course, the broker wants to protect his funds, so in the automated trading system, he sets a threshold for loss under the agreement, equal to the amount of your collateral / the amount of your account – $ 100. This means that if you incur losses in the course of stock market transactions, they will never exceed $ 100 – you will lose your money, and the broker will return his money without risking anything.
This is quite true, and this situation is called a margin call. However, in case of profit, all the money earned is left to you, and the broker will get back only his credit.
Advantages and disadvantages of financial leverage
As with all types of financing, leverage has its pros and cons. Advantages of such an agreement:
🔗 Borrowers can make relatively small initial investments.
🔗 Borrowers have the opportunity to acquire more assets through loan financing.
🔗 Under favorable conditions, financial leverage can lead to greater profits than ordinary business.
Disadvantages of leverage:
🔗 Assets are likely to decline rapidly in value and financial losses may increase.
🔗 Financial leverage is associated with greater operational risk for companies in the areas of automotive, construction and oil production.
🔗 Abuse of this type of financing can force companies to cease operations.
🔗 Companies that are less profitable and have unpredictable revenue streams may lose more when their assets decline in value. They may have to pay higher interest rates on loans because their risk is much higher.
Leverage ratio
The consumption ratio is used to determine the amount of a user’s debt relative to his disposable income. To calculate the consumer credit ratio, analysts can use the following formula:
Consumer credit ratio = total household debt / disposable personal income
The company’s financial leverage measures the debt-to-equity ratio by comparing the company’s total debt with its capital. In this case, the loan refers to the short-term and long-term debt of the company that brings interest, and capital is the sum of all interest-bearing debt with share capital, which may include all forms of shares.
To calculate the company’s debt-to-equity ratio, analysts can use the following formula:
Debt to equity ratio = debt / (debt + share capital)
Calculation of profit
To determine how much profit you can make using financial leverage, you must first measure the change in the value of the asset you acquire and then subtract the total investment. Add to this amount any interest you owe (total investment +% on debt).
To find the change in the value of an asset, use this formula:
Asset × (1 +% change in asset)
The change in the value of the asset must be in decimal form.
To find out how much profit you can make, use this formula:
Asset × (1 +% change in the value of assets) – (Total investment +% on debt)
Conclusion
Whether you are a newcomer to the stock market or an experienced trader, you should not rule out a lucrative deal, even if you do not have enough money. Calculate the risks, choose a strategy and contact a broker – he will always give you a leverage.
