Financial Leverage: What it is, Types, and How to Calculate It

There are different ways to boost the various types of real estate investments, some are easier than others, but all come with both advantages and risks. In the following post, we'll be discussing one of the most commonly used strategies: financial leverage. We'll explain what it is, its types, how it works, how it's calculated, and everything else you need to know to perhaps start implementing it.

What is financial leverage?

Financial leverage is a strategy that involves taking on debt to increase the return on an investment. In other words, it means investing more capital than is actually available, thanks to financing obtained through loans or credit.

Types of financial leverage

There are three types of financial leverage, all quite simple to understand:

Positive leverage

This is the ideal scenario. It occurs when the return on investment is higher than the cost of debt. In other words, the profits generated by the investment exceed the interest and other costs associated with the debt, resulting in an increase in the net asset value for shareholders.

Negative leverage

This occurs when the return on investment is lower than the cost of debt. In this case, financing costs exceed the profits generated by the investment, which, consequently, results in losses for the company and decreases shareholder value.

Neutral leverage

Finally, neutral leverage occurs when the return on investment equals the cost of debt. Here, the profits generated exactly cover the financing costs, resulting in neither losses nor additional gains.

How does financial leverage work? 

Financial leverage works by using debt to finance profitable investments, with the goal of increasing the expected return. The basic principle is that by borrowing money, a company or individual can invest in projects or assets that they otherwise couldn't finance with their own capital. If these projects generate a return higher than the cost of debt, the company or individual increases their profits and, if applicable, shareholder value. We'll explain it more simply as follows:

• The company or individual borrows money through loans or by issuing bonds.
• This debt has a cost, which is the interest that must be paid.
• The borrowed money is used to invest in projects, purchase assets, or expand operations.
• If the investment is successful, the profitable passive income generated will be greater than the interest that must be paid.
• For example, if the company borrows at 5% interest and the investment generates a 10% return, the company earns an additional 5%.

How is financial leverage calculated? Step by step

Calculating financial leverage is relatively straightforward, provided you have the correct data. We'll explain it step by step:

Step 1. Identify the necessary data

• Investment value: The total amount invested in the project or company.
• Own capital invested: The amount of capital you have contributed.
• Debt: The total amount owed to third parties for the investment (if applicable).

Step 2. Select the appropriate formula

• If there is no debt: Financial leverage = 1: (Investment value / Own capital invested)
• If there is debt: Financial Leverage = Debt / Total Invested Assets

Step 3. Perform the calculation

Substitute the corresponding values into the chosen formula; the result will indicate the degree of financial leverage.

Step 4. Interpret the result

• High financial leverage (greater than 1): This indicates that a significant amount of debt has been used to finance the investment. While this can amplify gains if successful, it also increases the risk of losses.
• Low financial leverage (less than 1): This means the investment has been primarily financed with equity, reducing risk but also limiting potential returns.
• 1:1 financial leverage: This represents an intermediate situation where half of the investment is financed with debt and the other half with equity.

Step 5. Leverage assessment

The financial leverage ratio alone does not indicate whether the strategy is appropriate. It must be analyzed in conjunction with other financial indicators, considering factors such as risk tolerance, investment outlook, and overall financial situation.

Advantages of financial leverage

Financial leverage is a popular strategy among expert investors due to its numerous benefits. Below, we highlight its main advantages:

Capital multiplication

The main appeal of financial leverage is its ability to multiply capital. By taking on debt, investors can increase their investment amount, which, of course, potentially boosts profitability. This means that with a smaller amount of their own capital, it's still possible to access large investments and achieve greater returns.

Access to larger-scale investments

This strategy allows investors to access investment opportunities that would otherwise be out of reach due to high minimum investment requirements. By financing part of the investment with debt, it's possible to participate in larger and potentially more profitable projects.

Increase in Internal Rate of Return (IRR)

Using leverage increases the internal rate of return of a financial operation. Because a portion of the investment is financed with debt at a cost lower than the expected return on the investment, the IRR is significantly improved, making the investment more attractive.

Strategy for short-term financial goals

Financial leverage is an effective strategy for achieving specific short-term financial goals. By increasing the capital available for investments, we open up the possibility of generating higher returns in a shorter period, thus facilitating the attainment of specific financial objectives.

Portfolio diversification

Using this investment strategy allows for quite efficient diversification of an investment portfolio. By having additional capital through borrowing, one can explore different sectors or asset classes, reducing the overall portfolio risk and improving its resilience to market fluctuations.

Risks of financial leverage

It's clear that this investment strategy offers significant benefits, but it also carries substantial risks, which include:

• Interest costs: The biggest disadvantage of financial leverage is the obligation to pay interest on the debt, regardless of the investment's performance. 
• Potential for losses: Using debt to finance investments increases the risk of incurring losses. If the investment does not perform as expected, not only will the equity capital be lost, but debt obligations will also still need to be met.
• High risk of insolvency: This strategy is high-risk and can lead to insolvency if not managed properly. 
• Dependence on the credit market: The viability of financial leverage largely depends on credit market conditions. For example, during times of financial crisis, access to credit is often restricted.
• Impact on credit rating: Excessive use of leverage negatively affects a company's credit rating. A higher debt burden could be viewed as a risk by lenders and rating agencies.

Example of financial leverage

To see how financial leverage works in practice, let's consider the following hypothetical example:

The company CONTROL wants to expand its operations and decides to use financial leverage to fund a new line of savings financial products.

Step 1: Securing Financing

CONTROL company has $500,000 in available equity, so they decide to request an additional loan of $1,000,000 with an annual interest rate of 5%.

Step 2: Investment in a New Product Line

With $500,000 in equity and a $1,000,000 loan, the company now has a total of $1,500,000 to invest in the new product line.

Step 3: Investment Results

Once installed and operational, the new product line generates annual revenues of $300,000. After paying loan interest ($50,000 annually), the company has a net profit of $250,000.

Step 4: Financial Leverage Analysis

• Without Leverage: If the company had only used its own capital of $500,000, the net profit would be $150,000 ($300,000 revenue - $150,000 costs).
• With Leverage: By using $1,500,000 ($500,000 equity + $1,000,000 loan), the net profit is $250,000 after paying interest.

This example clearly demonstrates the power of financial leverage, as by utilizing it, CONTROL has managed to increase its net profit from $150,000 to $250,000, representing a 67% increase.

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Conclusion

In conclusion, financial leverage allows for the amplification of investment returns through the use of borrowed funds. However, its use carries significant risks that must be managed with information and contingency plans. Always remember to assess your willingness to face losses and, above all, if you can truly afford them.