What is Financial Leverage? Types & Potential Risk Explained

Leverage, in general, means to use something to one’s advantage. In the context of finance, it means borrowing money by individuals or companies to invest the funds or buy assets for business growth. It is a kind of investment strategy that uses multiple financial instruments to increase the returns on investments.

Table of Content

• What is Financial Leverage?
• Different Types of Financial Leverage
• Potential Risks Associated with Financial Leverage

Financial risks often arise from how a company manages leverage and its debt servicing ability. Having a better understanding of different types of financial leverage and the potential risks involved can help you make the right decision and manage your finances better.

What is Financial Leverage?

Financial leverage involves the practice of borrowing money to boost potential investment returns by using debt rather than equity. It is through financial leverage that companies can buy assets that they might not otherwise be able to afford.

For investors who do not avail personal loan they can also benefit from financial leverage, such as by investing in companies that use debt to expand their businesses. To multiply buying power in the market, investors use financial leverage. At the same time, companies use it to invest in growth strategies for their business. The financial ratio used to compare a company’s debt to its equity or assets is how financial leverage is measured.

Different Types of Financial Leverage

Financial Leverage

In this type, companies and businesses borrow money in the form of loans and bonds to buy assets or start a new venture with the hope of generating more income than the interest on the loan. This is called financial leveraging. A major benefit of financial leverage is that it allows businesses to raise money without selling equity. It is also ideal for businesses that have limited assets. Financial leverage can be of great advantage when the returns being generated surpass the interest costs of the debt.

Financial Leverage in Investments

In this type, investors can use their available loan amount from the broker as leverage to make investments more than they can afford. It is also known as buying on the margin or margin trading, which allows investors to increase their returns in case their investments perform better than the cost of the loan itself. Apart from margin trading, the other two leveraged investment strategies are options trading and leveraged-ETF trading. However, all of these also expose the investor to higher risk.

Financial Leverage in Personal Finances

Leveraging your existing resources is a way to multiply and expand your resources, such as an individual availing of a loan to purchase an asset, like a machine or other tools & equipment that would allow them to grow their capital in the future. It is a strategy that an individual may use the borrowed funds for personal finances, with the aim of generating returns that would exceed what they borrowed. For example, an individual might purchase a house in a Tier I city to rent it, such as a guest house, which is likely to generate income over time.

Financial Leverage in Professional Trading

This type of financial strategy is very similar to that of margin trading. However, the returns are as high as the risk. Even though a professional trader has the prerogative to borrow a higher limit of capital than an individual does. However, the trader must have an in-depth knowledge and experience to use financial leverage in their day-to-day trading. 

Suggested Read: Understanding Financial Security: Meaning, Importance & Benefits

Potential Risks Associated with Financial Leverage

Some of the potential risks associated with financial leverage are as follows:

• Volatility: Fluctuations in interest rates or decreases in asset returns may complicate the process of offsetting interest expenses.
• Short-term gains: Some assets may experience rapid declines in value.
• High risk: This approach can be complex and carries considerable risk, particularly for novice investors.
• Uncertain rewards: Although it has the potential for substantial gains, it can equally amplify losses.

Financial leverage allows companies to borrow money to expand their operations, with the aim of growing beyond their existing capital and allows investors to earn higher returns depending on their investment choices.

Being the most trusted financial services company in India, Muthoot Finance helps businesses and individuals attain financial leverage by offering a range of loan solutions, such as personal loans, business loans,gold loans, etc. For more information, visit your nearest Muthoot Finance branch.