What is leverage ratio with proper calculation

Financial leverage basically consists of borrowing to invest and it is often used by both companies and individuals. The use of this investment system is booming among investors. What is leverage ratio with proper calculation

Its operation is based on resorting to debt, which allows the user to invest more capital than he has thanks to the one he has borrowed . This method has the characteristic that it allows an investment to be made even if there is not all the money necessary for it, at the same time that the profitability of what is invested can be maximized by the involvement of more capital, so that if the operation goes well , the benefits grow considerably.

In addition, the fact that financial leverage allows us to invest more capital than we have makes the profits (or losses) derived from the operation greater than if we had only used our capital.

The method can be done by requesting debt or through financial derivatives. The more debt you use, the greater the degree of financial leverage . The investor must take into account in the leverage operation the interest to be paid on the borrowed money that could negatively affect earnings.

For all this, the final balance of a financial leverage can be positive -if the operation generates benefits in the investment-, negative -if we experience losses in the invested capital- or neutral -when the profitability obtained is equal to the invested capital-.

How financial leverage is calculated What is leverage ratio with proper calculation

To calculate the degree of financial leverage, it is usual to use fractional measures, so that if we talk about a leverage of 1: 2 we are saying that for every euro invested of our capital, we are actually investing two euros (one of our own and one borrowed) And therefore the debt also amounts to one euro. There is a formula to calculate the financial leverage of an investment: 

       Investment value

Financial leverage = 1: ——————————–

  Invested own resources

Let’s say, for example, that we have invested 2,000 euros of our money but the total value of the investment is 20,000 euros. In this case, we will be using debt or derivative products to increase the capital of the operation. In that case, based on the formula above, the leverage will be 1:10.

20,000

Investment financial leverage = 1: ———- = 1:10

 2,000

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