What is leverage?

The word leverageIt is a word that is used regularly to clarify a concept that has to do with debt, however many people think that this word refers to a physical theft procedure due to ignorance. To avoid that, today we are going to talk about what that word means and how it can be used in economics, at the same time as telling you what the most popular advantages and disadvantages are.

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

What is leverage?

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

This procedure gives benefits

East 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 superior to the one we have; In spite of everything, it can 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, within a year, these shares will cost 1.5 million euros and later we decide to sell them. In this circumstance, we have achieved 50% of total profitability.

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

Per year, the shares are worth 1.5 million euros and you decide to sell them.

You sell them and you must pay what you owe. The first without 80,000 euros to the bank of the interest that your credit has caused and later returns 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. From that benefit we get 880 thousand that are in debt and our initial 100,000 that are not profit because we already had it. The remaining profit we have left is 420 thousand.

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

The risks of financial leverage

Now we move on 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 increase profitability to 1.5 million, it has dropped significantly and has reached 900. Here, from the beginning, 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; In spite of everything, 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 are asking for plus interest, which can triple our debts.

In this circumstance, the leverage is not profitable but it is somewhat random, since it is not feasible to know for sure if the shares will rise or fall in a year, even though in some cases if you can have some forecast.

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

Be in a comfort zone With this type of process, you should always pay attention 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 that even if a leverage goes wrong, it can be in a safe zone, since it will begin to be solvency as the company gains.

The beating in finances.

In the world of finance, anyone establishes leverage as a link between the capital that a person has and the credit he has.

How much does the bank usually give in a leverage procedure?

To give you a little idea, for every euro you have from 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 the bank could get your money back, but with a higher %, the losses for the person will be too great and, consequently, also for the bank.

Where does the financial leverage come from?

This system was produced for the first time in 2007 when the real estate bubble was generated in the United States and Spain. In this circumstance, 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 debt.

Why it should be used for leverage through debt or a 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 operations without running out of credits.

Who can use financial leverage

Even though any sector can use leverage, it is the financial sector that exploits this method the most, since it is the sector that requires the most profitability.

Not all companies dare to leverage financially. Why?

With most leverage, there is a risk that things will not work out well, which can lead to the company may go bankrupt. In several cases, the interest on the credit they have given and the credit itself, cause losses that cannot 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 always have to have an extra creditworthiness outside of that leverage in case things do not go well. When we say that a transaction is leveraged, in fact we 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 generally have to pay higher interest on 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 believe.

Later, you should also know the degree of leverage that they provide us. As an 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, it will give us 2 euros of credit. When they tell us 1: 3, it will be 3 euros from the bank for every euro that we enter.

If we put it at 1: 4 with a very large amount of money, the interest 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 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 said that a shareholder makes a personal loan in order to improve the leverage of said company and from this dynamic, the money would be owed to someone in the company and not to third parties outside of it. In this circumstance, for the shareholder, what is done is deleveraging through an increase in capital bonds.