What is Financial Leveraging and how does it work?
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(Please note that this article is not professional investment advice. It is an attempt to educate our readers on all developments in the financial world. If investors choose to purchase any relevant stocks after reading this article, They do so based on their own judgement.)
Leveraging is an important tool that can improve many areas of your life.
You may have heard of it in skills like time management or utilizing social connections to your advantage.
It also has an important use in Finance and Investing.
Source: Photo by Matthias Zomer: (https://www.pexels.com/photo/person-signing-document-paper-618158/)
Financial leveraging, in simple terms, is using other people’s money to accelerate your returns.
Beware, for this tool is a double-edged sword and can put you into debt.
We will get into exactly how it can greatly harm investors towards the end.
How does Financial Leveraging work?
Financial leveraging as a concept is simple.
There are two scenarios that need to be considered.
One is for companies and the other is for investing individuals.
Looking at companies, we find that firms often need outside capital to generate returns.
This may be because company equity is too low, or the firm wants to use more than one source of funding to invest in new ventures.
Try this example on for size.
Rhinestone Jewelry, a company that sells gold and silver ornaments, is deliberating on opening a new store in the Middle East region.
They have $200,000 of their own money.
The cost of opening a store is $1,000,000.
They now have three options when it comes to raising the remaining $800,000.
They can gather cash from keen investors (equity), take on a loan from a bank (debt) or engage in a combination of the two.
Whatever decision the firm makes, there is a pro that comes from taking on debt.
If the store yields a return higher than the interest payments, Rhinestone Jewelry can take on $800,000 of debt, pay interest and principal with returns from the new store and put the remaining money in their company account.
This is an age-old idea for companies and many multinational corporations are always in some form of leverage.
Photo by Tirachard Kumtanom: (https://www.pexels.com/photo/woman-writing-on-a-notebook-beside-teacup-and-tablet-computer-733856/)
But leveraging is not limited to companies; investors are always offered this tool by their broker or an investing platform.
If the investor feels a stock is going to go up in value, they can take on debt from the broker to accelerate returns.
The downside to this is obviously, if the stock loses some or all of its value, the investor has to pay back whatever has been lost by the brokerage.
This service also comes with fees attached, which is added on to the missing principal, making it more expensive as leveraging is a service provided by brokerages and not free.
What could go wrong with leveraging?
The simple answer: a lot.
Leveraging is a valuable tool in finance and investing only if you’re sure about your investments.
It’s something veteran investors or financial professionals rely on mostly.
That being said, it is not unavailable to the public.
Any investor, amateur or professional, can easily find a platform that provides leveraging capabilities.
Please make yourself aware by reading this article and the reference links to understand what you are getting into.
This article is sourced from the following links:
What Is Financial Leverage, and Why Is It Important? (investopedia.com)
Financial Leverage - Learn How Financial Leverage Works (corporatefinanceinstitute.com)
Understanding Leverage in Finance - Naukri Learning
Leverage - Definition, What is Leverage, and How Leverage works? (cleartax.in)
Financial leverage definition — AccountingTools
