Financial leverage is a strategy that involves using borrowed funds for investment, with the expectation that the profit made will be greater than the interest payable. Using financial leverage can increase the return on investment if the interest paid on the borrowed money is less than the return made on the investment. However, it can also increase the financial risk of the enterprise, as there is a need to repay the borrowed funds regardless of whether the investment wins or loses.
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1. How does financial leverage work?
Financial leverage works by using borrowed monies to fund investments. If the investment turns out profitable, the return is used to pay off the interest on the borrowed money and the rest is pure profit. If the investment doesn’t turn out well, the borrower will still have to pay the interest, therefore increasing his financial risk.
2. What are examples of financial leverage?
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There are various examples of financial leverage including buying shares of a company on margin, real estate investments using mortgage loans, and companies sometimes use leveraged buyouts to acquire other companies.
3. What are the benefits of financial leverage?
One major benefit of financial leverage is that it can magnify returns. If the returns on the borrowed funds are larger than the interest needed to be paid, then you will have more profit. Also, the interest payments on debt are tax-deductible which can reduce a company’s tax liability.
4. What are the drawbacks of financial leverage?
Financial leverage can increase potential returns, but it also amplifies potential losses. If the investment doesn’t earn a return above the cost of debt, the losses are also larger. Furthermore, if the investor is unable to make the interest payments, then it might lead to bankruptcy.
5. How can one manage the risks associated with financial leverage?
It is recommended to balance the use of financial leverage with the risk tolerance. One should only borrow the amount that they can afford to repay, keeping in mind that the investment may not always yield a positive return. Diversification of investments can also help to manage the risks associated with financial leverage.