Leverage calculation: how is it performed?
Being able to make money in the stock and financial markets is often a feat, the result of skill, a dash of luck, but also shrewd strategy. Have you guessed what we are talking about today? About...financial leverage!
The celebrated mathematician and surveyor Archimedes said, in what will remain one of his best-known phrases, "Give me a lever and I will lift the world." Of course, Archimedes was not really thinking about leverage, but the logic behind it is the same for understanding how leverage works.
Leverage is a key debt calculation tool in business investment regulation and for anyone involved in trading. An important indicator for any business, it can prove crucial for Appvizer's audience.
In this article we will take care to explain what it is and expose how leverage is calculated. So what are you waiting for? Let's go!
What is leverage? Definition
Also called debt ratio or leverage in English, leverage is an indicator or, rather, a coefficient applied in the stock and financial market, which allows traders to increase their financial capacity.
Increasing the financial capacity of investors occurs through the use of a broker. Indeed, the latter will enable the company to come into possession of more liquidity: it will provide more money than it actually has available.
Thus, the broker plays the role of an intermediary who lends the money necessary for the company to be able to gain a position in the market while having minimal investment capital available.
Put simply, the calculation of leverage lets you know to what extent you can indebt your company: you can, therefore, sell and buy financial assets for an amount greater than the capital actually held by the company.
Why would a broker be interested in lending you the money you need for your investment?
The answer is simple: the broker gets rich from the interest you pay him on the loan he has given you.
As they would say overseas, "It's a win-win relationship": you get the money you need for your investments and the broker collects interest on the loan you were given, you are thus both winners!
The benefits that leverage can bring are all related to how you use it. In fact, it is a double-edged sword: it can increase the profit made from a financial investment just as it can lead to the risk of being subjected to major losses, since you are relying on more capital than you actually have. Therefore, always try to make proper and wise use of it.
What is leverage used for?
Leverage is a tool for increasing the degree of exposure in the market following a modest-sized investment. In fact, only a portion of the total investment amount is invested, while the rest is made available by the broker.
The leverage mechanism allows the firm to incur losses or accumulate relative profits, that is, losses or profits that will be realized on the total sum resulting from the investment.
The initial outlay in the leveraged investment transaction is also called the margin or deposit requirement. This generally corresponds to only a small part of the entire exposure. Its amount varies depending on several factors, among which the type of market in which it is employed (whether liquid or volatile) is crucial.
The margin deposit can be fixed or calculated as a percentage of the value of the position, depending on each particular case.
Leverage allows one to assess the ratio of equity to debt capital. This allows one to be more confident in choosing one source of funding over another. A source of financing can be:
- External when debt is made.
☝ The strategy of using an external source of financing, i.e., debt, is very common in companies. In fact, it is often the belief of them that they can earn revenues that exceed the cost of the interest to be paid on the debt.
- Internal, when using equity, that is, the company's own resources.
☝ External financing is used when it is intended to improve the profitability of equity.
The use of corporate debt
Companies use external sources of financing, i.e., debt, because these are, in general, cheaper. In fact, the cost of third-party capital (from banks or other lenders) is, in general, lower than the cost of venture capital, especially if long-term debts are made.
In addition, debt normally generates some tax advantage, since finance charges, i.e., interest expense, can be deducted from pre-tax profit when preparing the annual financial statements. This results in a lower final tax amount and, therefore, an increase in the value of the business.
However, the higher the debt ratio, the more risky the company is estimated to be. An increase in risk, however, corresponds to a higher expected profit for the lenders. This means that the borrowing costs borne by the company in order to receive financing will also be correspondingly high.
So, an increase in the value of the leverage ratio is expressed in an increase in borrowing costs. Indeed, as we have seen, higher interest rates intervene in this case. But it should also be considered that the charges themselves are calculated on a broader basis.
From the latter considerations, it is easy to deduce that leverage can highlight some substantial risks: if its value is very high, there is a risk that the company will go bankrupt, in case of unprofitable investment.
For this reason, it is worthwhile for a company to opt for leverage for investor purposes only if the expected gain from the investment is greater than the amounts received in debt.
How does leverage work?
So, leverage works on the basis of a broker making available to the company making the investment a certain credit, thanks to which more liquidity will be available for investment. Normally, the whole process takes place through the mediation of a trading software.
Leverage results in specific effects: if the effect of leverage is high, financial markets are made more accessible to investors, especially those with limited capital.
Leverage can be used on most markets: stocks, commodities, forex, indices, ETPs, bonds, etc., and is available for a wide range of products.
Leverage calculation
In order to perform the leverage calculation, it is necessary to have the balance sheet of the reclassified financial statements and, in particular, the sources and uses item.
In fact, the calculation of leverage is given by the ratio of the amount invested to the amount of capital held. In other words, it is necessary to divide total liabilities, that is, the total sum of sources of financing, by equity.
👀 The higher the leverage, the higher the return.
Thus, the calculation of leverage can be done by applying the following formula:
Financial leverage = amount invested (current liabilities + fixed liabilities) / equity capital - shareholders' equity
So, the value of leverage varies according to the capital held and the amount invested: the higher the value of leverage, the greater the amount that can be invested. This also means that the higher the value of the amount invested, the higher the amount the company actually holds, the higher the effect caused by leverage.
Caution. Several ratios can be used to measure leverage, not just one. There are the leverage 1 to 10, 1 to 100, 1 to 50, 1 to 2, and so on.
If, through the calculation of leverage, high values are obtained, it means that the money invested in the company (i.e., equity) is more profitable than the interest on the debt. It also means that the company is undercapitalized, that is, it has more debt (i.e., obligations to repay) than equity.
If leverage, on the other hand, takes low values, it means that the firm has access to little financing. In turn, this means that equity exceeds debt, which translated can be interpreted as little risk and return for the firm.
So, the level and value of leverage are not always the same, but change from trade to trade depending on the amount of the amount actually invested.
Practical examples of leverage calculation
Suppose a company wants to:
→ Buy shares worth 100,000 euros.
Through the mechanism of leverage it is possible to buy the shares through the intervention of some brokers, simply by paying a small part, a margin in fact, of the entire sum. All while maintaining a degree of total exposure.
Suppose:
→ The initial margin requirement is 10% of the whole sum, then you will have a total margin of 10,000 euros.
In case of:
→ Increase in the share price, for example from 1 (assumed initial price) to 2 euros, you will make a duplicate profit, despite having paid only part of the entire share price.
Calculation of leverage on shares
The calculation model just seen was performed on an example of investment on stock markets, that is, specifically, of an investment involving the purchase of shares.
Stocks, in fact, are the most popular instruments for CFD (Contract for Difference) traders . In fact, CFD brokers are generally the ones that allow trading in the largest equities.
☝ It is important to mention, that through CFDs it is possible to trade investments on different financial instruments. These include cryptocurrencies, currency pairs (forex), stock market indices, commodities, etc.
Benefits and risks of leverage
It might seem that, with leverage, only advantages are attached. In fact, as just seen, through this mechanism it is possible to make a maximum profit while investing only a small part of the total amount required to make the investment.
This is a fact, and it does not change. Pay attention, however, to the fact that leverage implies a total exposure margin for both profits and losses.
This means that if a company using leverage, instead of a gain from an investment, were to suffer a loss, this too would be considered in its entirety. The loss, like the gains, will, in fact, be related to the total result from the investment, not just in the percentage actually invested by the company, i.e., the initial deposit. The investor should always keep the leverage indicator at bay, because just as it can be a source of major benefits, it can result in major losses to the firm. It is therefore of primordial importance to make proper and informed use of leverage in order to reap the maximum benefits. The greatest risk concerning leverage comes from lending institutions, namely banks. If several years ago the bank was constantly trying to monitor and keep a credit granted to maturity on its balance sheet, nowadays banks are no longer interested in such a balance sheet. On the contrary, they are constantly on the lookout for new intermediaries eager to take over part or all of a given financial intermediary.
Put in simpler words, banks are simply selling off their debtors to others. This operation allows them to recover the cash they need in a minimum time frame and be able to reuse it as a credit offer for a new customer.
So, it can be said that leverage not only amplifies profits, which can be very high, but also potential losses. The latter can also, therefore, exceed the amount invested, that is, the initial deposit, in the case of particularly unfavorable markets.
Also to keep in mind is the fact that brokers apply what is called the "margin call": a margin call threshold is set at a level lower than the margin actually used for the trade. That way, should the loss on your position exceed this threshold, the trade is automatically closed.
If you are a Hollywood movie lover, you can understand the concept in a playful way by watching the movie "Margin Call": the movie retraces the themes we have encountered in this article 😆
Don't worry, there are numerous opportunities in the online trading market in order to avoid large risks of loss. One among these many solutions is the " stop loss". This is an automatic assessment of the risk of loss even before you open a trade: in a nutshell, you have to decide from the beginning how much you are willing to lose.
Once the predetermined level is reached, the trade is closed, thus preventing you from incurring further losses.
Despite all these aspects that may seem negative and discouraging, leverage, if monitored properly, also has other advantages, such as:
- The availability of greater liquidity, since it allows you to invest only small amounts;
- Better management of equity (allowing diversification of investments);
- Broadening investors' exposure to markets .
Leverage, therefore, is a tool that allows traders to make investments at a higher sum than the value of the capital held. For this reason, it is a very important indicator for increasing investors' exposure on various markets.
What about you, have you ever made an investment through the leverage ratio? If the answer is yes, please share your experience with us in the comments section below! If not, feel free to share any doubts or uncertainties with us-the answers provided by our staff may help you!
Article translated from Italian