Man climbing a rope
Financial leverage is a process that involves borrowing resources that are combined with existing assets and used to produce the desired result in a financial business. In some cases, financial leverage is used to increase the chances of increasing the return on capital or some type of investment in the stock market. At other times, the strategy can be used as a means to lock in a specific outcome that could be detrimental to the investor in the long run.
As part of the leverage process, loans can take many forms. Loans for additional cash resources can be a means of starting a leverage strategy. Acquiring debt, such as acquiring a competitor’s mortgage, is another means of gaining some degree of leverage on a given business move. Investment trading on margin given to an investor by a brokerage firm can also be seen as a form of financial leverage.
The degree of financial leverage required to achieve the desired result varies based on a number of factors. First, there is the relationship between available assets and the amount of loan or acquired debt that is needed to operate the business successfully. This is a key element, as an unfavorable financial leverage ratio between assets and loans or debt can put the entire strategy at risk and create serious financial difficulties if the operation does not go as planned.
In addition to maintaining a favorable ratio, it is also important to measure the degree of financial leverage inherent in the proposed business. The best way to understand what is meant by degree in relation to leverage is to project the percentage change in the value of profits or losses of each share or unit involved in the transaction. This grade is calculated before applicable interest or taxes are earned, not after.
Operating financial leverage is another factor to consider. In its broadest application, this factor has to do with the positive or negative impact that the leverage process is likely to have on the overall operation of the entity initiating the proposed strategy. In terms of an individual investor, it is important to consider whether the leverage process will temporarily inhibit the individual’s normal financial operations or whether the individual can continue to function financially without making changes or concessions.
The focus of any type of leverage is usually to improve the financial position of a person or entity in some way. The approach is often employed when there is a very good chance of success, and that success can be increased significantly in terms of performance by augmenting existing resources with ones that are borrowed at short notice. As with any type of financial growth strategy, it is a good idea to research the possible outcomes of any financial leverage strategy before embarking on the strategy. This means looking at worst-case scenarios as well as the gains that could be made under the best of circumstances.