Why is Financial Leverage Important and How Does It Work??
Financial leverage has become increasingly prevalent in financial markets and is a widely followed practice. Understanding the concept of financial leverage can help you make smarter investing and borrowing decisions. So, what is financial leverage, and what are its various aspects? Let’s find out.
Financial Leverage Meaning
You can define financial leverage as a funding source and a way of using borrowed money to boost investment returns. For instance, you want to start a business but don’t have enough funds. You can borrow money through financial leverage, which increases the amount you can invest.
This potentially increases your chances of making profits if your business performs well. However, financial leverage can be a double-edged sword. This is because if your business fails to do well, it can increase your losses as you need to pay the borrowed money with interest.
Expressed as a ratio, financial leverage shows the proportion of borrowed funds to your capital. A high leverage shows a higher amount of borrowed funds and vice versa.
Importance of Knowing Financial Leverage
Understanding the concept of financial leverage is crucial for these reasons:
- Helps in Better Financial Planning
This is one of the foremost benefits of financial leverage. It can help you better plan your finances and make intelligent decisions on how much debt you want to take. As financial leverage entails borrowing, you need to pay EMIs. Understanding leverage can help you decide how much funds you need to take without overburdening yourself under high EMIs.
- Aids in Risk Management
A holistic understanding of financial leverage can go a long way in prudent risk management. Higher leverage entails higher debt and, subsequently, higher EMIs, so you can use financial leverage to assess whether the risk is worth taking. While high rewards accompany high risks, it’s not the case on most occasions and can jeopardise you and your finances if not used wisely.
- Making Wise Investment Choices
Understanding the concept of financial leverage can help you make wise investment choices and not waste the borrowed funds. Be it borrowing funds to start a venture or using a margin trading facility to amplify your buying power, a robust grasp of the concept can help you make investments in profitable asset classes or business projects. Repayment becomes easier when you use funds wisely for growth.
Working of Financial Leverage
Let’s explain financial leverage working with an example. Suppose you want to start a business and require ₹10 lakhs for it. You only have ₹5 lakhs, and you borrow the rest of the amount at an annual interest of 10%. Your business earns a profit of ₹2 lakhs.
After paying an interest of ₹50,000 (10% on ₹5 lakhs), your profit stands at ₹1.5 lakhs. On the other hand, if your business makes less than ₹50,000, you tend to lose money and cover the losses from your pocket.
Calculating Financial Leverage
Financial leverage is calculated using the debt-to-equity ratio, which is essentially the proportion of borrowed funds to your capital or equity. The formula for this is:
Total Debt / Total Equity
In the above case, your financial leverage stands at 1:1 (₹5 lakh / ₹5 lakh). It means for every ₹1 of your capital, you are using ₹1 of debt.
Conclusion
If used wisely, financial leverage can position you to grow your wealth and achieve your financial goals. However, if your investment fails to do well, it can result in significant losses. With a wide range of funding options available today, it’s vital to use them cautiously and not go overboard. Borrowing an amount you can easily repay not only eases your finances but also ensures you avoid a debt trap.
Disclaimer: This article is for informational purposes only and does not constitute financial advice. It is not produced by the desk of the Kotak Securities Research Team, nor is it a report published by the Kotak Securities Research Team. The information presented is compiled from several secondary sources available on the internet and may change over time. Investors should conduct their research and consult with financial professionals before making any investment decisions. Read the full disclaimer here.
Investments in the securities market are subject to market risks, read all the related documents carefully before investing. Please read the SEBI-prescribed Combined Risk Disclosure Document before investing. Brokerage will not exceed SEBI’s prescribed limit.
