The concept of leverage: Calculation, benefits and risks

​ In the world of finance and investing, leverage acts as a double-edged sword that can both significantly increase your profits and amplify potential losses. Leverage has applications ranging from buying property to actively trading the stock markets. In this article we will discuss all the nuances of leverage: how it works, what are its advantages and risks, and why the competent use of this tool can be the key to financial success.

What is leverage?

Leverage is the use of borrowed funds to increase the investment potential of an economic player: a company, a financial institution or an individual. This mechanism allows the purchase of an underlying asset worth more than the user has in monetary assets. Although the concept of leverage may seem abstract, this mechanism is familiar to everyone. For example, it is used in rental investments: if a person invests in a rental property using credit, they expect the rent received to exceed the cost of the loan and the value of the asset to make a profit.

From an accounting perspective, leverage measures the effect of capital provided by third parties relative to a company's equity. Specifically, this concept allows a company's financiers to determine the extent to which they can accept an increase in debt. Thus, before making an investment, a company calculates the leverage effect to assess its profitability. If the leverage is positive, it means that the investment is profitable. If negative, on the other hand, capital is lost. This issue concerns all participants in economic activity: individuals wishing to invest in property or finance, banks and investment funds making financial investments, etc.

Leverage limits

Leverage allows you to increase the level of investment and profit from the initial capital, but this mechanism works both ways. If economic profitability exceeds the cost of debt, leverage has a positive and favourable effect on financial profitability. In the opposite case, the leverage effect leads to multiplication of losses. The higher the leverage, the stronger the "boomerang effect" or "sledgehammer effect".

Similarly, in the banking sector, the amount of credit extended logically exceeds the level of equity capital. Therefore, the financial position of banks can be weakened if loans are not repaid. This was the rationale behind the introduction of prudential rules that limit the level of loans relative to equity capital (bank solvency ratios). Deferred securities and complex derivatives can be purchased on the stock market. This allows the trader to invest more than the down payment. Caution should be exercised as there is a real risk of capital loss.

However, leverage has a limit - it is the solvency of the economic player. In practical terms, maximum debt is estimated based on projected cash flow: the maximum amount borrowed is the amount that can be repaid from cash flow. Cash flow will be positive if working capital needs are covered by working capital. Therefore, it is advisable to use debt to a limited extent, especially if the company's business is cyclical in nature. Before taking on debt, it is important to assess the implications of the debt to ensure that leverage is favourable to the borrower.

How is leverage calculated?

There are several ways to calculate leverage. One of the simplest is to relate the amount invested to your equity. Remember that equity refers to a company's financial resources, excluding borrowed funds. It consists of the original share capital, reserves and retained earnings. Leverage = amount invested/equity. In other words, if you buy the capital stock for 20,000 EU but only own 10,000 EU, the leverage will be 2 (20,000/10,000).

Another calculation method takes into account long-term debt (E), equity (P), company profitability (e) and interest rate (i). The formula is as follows: leverage = (e-i) x E/P. From this formula, it is easy to understand that leverage depends on the difference between a company's profitability and its financing costs. We can also measure the impact of debt on the return on invested capital. This is known as financial and economic profitability.

Financial profitability is calculated as follows: Financial profitability = operating profit - income tax - interest paid on financial debt / equity. In Anglo-Saxon accounting, this ratio corresponds to "return on equity" or "ROE".

Economic profitability, on the other hand, reflects the economic efficiency of a company and is calculated as follows: Economic profitability = operating profit - income tax / capital employed (or economic assets). Capital employed = equity + debt. Thus, the leverage effect is calculated using the following formula: Leverage = financial profitability - economic profitability.

Examples of leverage risks

To illustrate the risks of leverage in property investments, consider the purchase of a rental property financed with a 20% down payment and an 80% loan. Leverage will be positive if the rent received exceeds the loan payments and the property value increases. If the property is sold, the owner will make a profit. Conversely, if the property remains empty or property market prices fall, the leverage effect will be negative and can even be dramatic, as in the case of the subprime crisis in the EU.

In addition, an illustration using the stock market example can shed light on the risks associated with leverage. In the example where the leverage effect is 10, capital of 1,000 can be used to invest in 10,000. If the stock price falls by 10%, i.e. loses 1,000, the investor will lose all his capital. Therefore, before taking on debt, it is necessary to evaluate the consequences to ensure that the leverage effect is favourable to the borrower.

Conclusion

It is important to remember that leverage is not a magic wand for instant enrichment, but requires careful analysis and a cautious approach. Before applying leverage, investors should carefully assess their financial capabilities and prepare for potential risks. Remember to consult financial experts and use only proven strategies to ensure that your investments are well managed. Proper use of leverage can be a powerful tool to achieve your financial goals if used wisely and carefully.