What is leverage

The word leverage, is a word that is normally used to explain a concept that has to do with debt, however many people think that this word refers to a process of physical theft due to ignorance. To avoid that, today we are going to talk to you about what that word means and how it can be used in economics, in addition to telling you what the most popular advantages and disadvantages are.

This or not in the financial world, is a term that you must know because you are going to hear it more than once.

What is leverage

When we talk about financial appeceamentWe are talking about a word that defines a debt process to finance any other type of operation. Let's explain this a little better: when are we going to carry out a financial operation but we do not want or cannot use our own funds in full, this is done with our own funds plus a loan.

This process gives benefits

This type of financial leverage processes it gives many benefits to the person or company that wants to carry it out; Among them, the one that is going to multiply the profitability since it is giving an investment higher than the one we have; However, it may also go wrong and instead of having expected profitability, you end up without any profitability in that operation, but it is a risk that is run in any financial operation.

We are going to give an example so that it is perfectly understood

Let's imagine for a second that we are going to carry out a transaction on the stock market that is going to cost us 1 million euros. We are aware that hopefully, after a year, these shares will cost 1,5 million euros and then we decide to sell them. In this case, we have achieved 50% of the total return.

If in this same operation, we carry out financial leverage. In this case, we would be putting only 200 thousand and the bank would be leaving us 800 thousand (1: 3). We also know the interest rate which is 10% per year.

Per year, the shares are worth 1,5 million euros and you decide to sell them.

You sell them and you have to pay what you owe. The first without 80.000 euros to the bank of the interest that your credit has generated and then return the 800 thousand that the bank lent you. Let's remember that we have won 1,5 million and we are doing the calculations on that. We take from that benefit 880 thousand that go into debt and our initial 100 thousand that are not profit because we already had it. The remaining profit that we have left is 420 thousand.

At this moment you are thinking that investing alone, you had earned 500 thousand and now you have only earned 420 thousand but you must realize that in those 500 thousand were your initial 200 so the real profitability was only 300 and not 420. This is the reason why the Financial leverage works and it works very well.

The risks of financially leveraging

Now we go to the second part, because everything that we have explained to you is very positive and with a very high profitability, but it is not what always happens.

We go to the same case but with a different scenario. Let's imagine that instead of raise profitability to 1,5 million, it has dropped significantly and has been placed at 900. Here, from the outset, we know that we have lost 100.000 euros if we have not leveraged and if we have done so we have already lost 180.000 euros.

It's here it comes the bad part of leverage, since in the first case, we have only lost our own money and nothing happens; However, in the second case, we have lost money and we also owe money to the bank, we have to return to the bank the entire amount we ask for plus interest, which can triple our debts.

In this case, the leverage is not profitable but it is something random, since it is not possible to know for sure if the shares will rise or fall in a year, although in some cases if you can have some forecast.

There are more catastrophic scenarios in which stocks fall even further. For example to 700. At this point we have lost everything we invested and also we have been left with a huge debt with the bank that surely we will not be able to solve.

To be in a comfort zone With this type of process, it should always be borne in mind that an initial investment must be made but in which we know that the income (when it is the case of a company) will be much higher. This is the only way in which, even if a leverage goes wrong, you can be in a safe zone, since you will begin to have solvency as the company gains.

The beating in finances.

In the world of finance, anyone defines leverage as a ratio between the capital that a person has and the credit they have.

How much does the bank usually give in a leverage process

To give you a little idea, for every euro that you have of your own credit, the bank will put up to 4 euros. It is highly unlikely that a bank will give you more, since in case it goes wrong, the bank could get your money back, but with a higher%, the losses for the person will be too great and consequently for the bank too.

Where does the financial leverage come from?

This system was given for the first time in 2007 when the real estate bubble was generated in the United States and Spain. In this case, it was thought that house prices would always be on the rise, but one day they began to fall and extreme measures had to be taken.

When to leverage financially

The condition for financial leverage to occur is that the return must always be higher than the interest rate give us in debt.

Why it should be used in leverage using a debt or loan

When we use this method, this increases the final capital that we are going to earn, since it is used for the expansion of the operations without running out of credits.

Who can use financial leverage

Although any sector can use leverage, it is the financial sector that exploits this method the most, since it is the sector that needs the most profitability.

Not all companies dare to make financial leverage. Why?

In most leverages, there is a risk that things will not work out well, which can cause the company may go bankrupt. In many cases, the interest on the credit that they have given and the credit itself, generate losses that will not be able to be covered and they realize that it would have been better not to have used this type of method.

What companies should know before carrying it out

In any leverage typeThe key is to invest more money than you have to achieve a great return, but you should always have extra solvency outside of that leverage in case things do not go well. When we say that a transaction is leveraged, we actually mean that a transaction has a debt in the middle (the debt we have with the bank).

When we leverage large amounts of money in debt, we usually have to pay higher interest about them, which in the long run can cause us to have problems returning the money to the bank or not earn as much as we initially thought.

Then, you must also know the degree of leverage that they give us. For example, when a bank tells us that it will give us a 1: 2 leverage, it tells us that for every euro we put in, they will give us 2 euros of credit. When they tell us 1: 3, it will be 3 euros from the bank for each euro that we put in.

If we put it at 1: 4 with a very large amount of money, the interest that we would have to pay to the entity would skyrocket.

External or internal leverage

When do you talk about a external leverageWe are talking about the leverage that is given by a company that issues a debt and based on the income from the debt, operations that have already been previously planned can be carried out.

When you talk about internal leverageIt is being said that a shareholder makes a personal loan in order to improve the leverage of said company and in this way, the money would be owed to someone in the company and not to third parties outside of it. In this case, for the shareholder, what is done is deleveraging through an increase in capital bonds.