What is leverage?

You’ve probably heard the term leverage at some point and had doubts about what exactly this financial concept consists of. Today in our blog we are going to explain what financial leverage is and what are its advantages and disadvantages.

What is leverage?

Financial leverage is going into debt to finance an operation . In other words, it consists of using debt to buy assets that in turn generate more assets for us.

The origin of this term can clarify its meaning a little more, since it comes from the “leverage” effect that we obtain with capital when using borrowed funds.

In short, the term leverage refers to debt, although in a more technical way. Let’s see it with an example:

If you want to make an investment, for example , buying a business that is for sale and to do so you ask for a loan. If the business prospers and you make profits then the leverage will have been positive.

Types of leverage

There are three types of financial leverage:

Positive leverage : When the return obtained is greater than the interest paid on the debt, that is, we have gained capital

Neutral leverage : It occurs when the return on our investment is equal to the interest on the debt

Negative leverage : It is the worst scenario, it occurs when the return achieved is lower than the interest we are paying on the debt.

In short , leverage is a way of getting into debt that may or may not turn out well . It will turn out well if the investment in which we apply the debt generates more profits than the interest on it (in the previous example with the profits generated by the business that we have bought) then we can say that the debt pays itself and is a good investment, our business would be paying for itself.

However, this operation can also go wrong , continuing with our example, if the business we have bought loses money, we will not only have to face these losses but also the interest generated by the debt.

In other words, leverage is an operation that can go very well or very badly, so we will have to analyze the operation carefully before launching into it.

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