What is leverage?

What is leverage
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Often it reads in economics that an operation has been done with leverage and someone may think you are talking about a theft by forcing a door with a crowbar, but nothing is further from reality. Today we will explain what the financial leverage and the advantages and disadvantages in this article.

Financial leverage is simply to use debt to finance an operation. As simple as that. That is, instead of performing an operation with its own funds, will be done with equity and credit. The main advantage is that you can multiply the profitability and the main drawback is that the operation did not go well and end up being insolvent.

Take a numerical example will be clearer. Suppose we want to perform an operation on bag, and we spend 1 million dollars in shares. After a year, the shares are worth 1.5 million dollars and sell. We have obtained a yield of 50%.

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What if we perform the operation with some financial leverage? Imagine then we put 200,000 dollars and a bank (or several, in a syndicated loan) we paid 800,000 dollars to an interest rate of 10% annually. After a year, the shares are worth 1.5 million dollars and sell. How much have we gained? First, we must pay 80,000 dollars of interest. And then we return the 800,000 dollars they lent us. That is, we gain 1.5 million fewer initial 880,000 dollars less than 200,000, 420,000 dollars Total dollars. Less than before, right? Yes, but actually our initial capital was 200,000 dollars and 420,000 dollars have won, i.e. 210%. The profitability has increased!

However, there are also risks. Imagine that after a year the shares are worth 1.5 million dollars but 900,000 dollars. In the case where there is no leverage we have lost 100,000 dollars. In the case with leverage we have lost 100,000 dollars and 80,000 dollars of interest. Almost double. But with an important difference. In the first case we lost money that was ours, we had 1 million we invested and lost 10%. In the second case we had 200,000 dollars and the bank must repay 880,000 dollars of the 900,000 shares were worth. Only recovered 20,000 dollars. That is, the loss is 90%. Losses also multiply leverage!

In addition, the worst, imagine shares worth 800,000 dollars pass. Not only we would have lost everything, but we could not afford to pay 80,000 dollars to the bank. We are insolvent. In the case of money never would have insolvency problems, but now.

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In addition, these examples I actions do not have to be speculative stock market, was to simplify. It may be time to buy a company to manage or make an expansion of the company. Provided that the investment will generate higher income than the interest will be in the safe zone, with returns multiplied. Otherwise the problems begin.

Leverage is usually defined as the ratio between equity and credit. For example, before we were at levels of 1: 4. For every dollar of equity, the bank put 4. Which is quite reasonable, since it allows an operation goes wrong (loss of 25%) and the bank is able at least to recover the borrowed capital. In addition, some leverage is good because it opens the door to investments that might not otherwise have access. There are other more subtle advantages were discussed in SMEs and Self. When leverage levels are higher risks are also greater, and in recent years we have learned (I hope) a lot of this, especially in the housing market.

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