How to use leverage in finance

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The leverage effect is for a company to use debt to increase its investment capacity. The profits obtained thanks to the debt thus become more important than the value of the indebtedness. This technique also concerns the effect on the profitability of invested equity. We are talking about financial profitability and economic profitability. explains how to calculate them.

A Self Financing Technique

Leverage is a self-financing technique that consists in increasing the profitability of the company’s equity by using indebtedness. Leverage is represented by the difference between the efficiency of equity and economic profitability. In the case where this difference is greater than the cost of the receivables contracted, then the leverage is said to be positive, otherwise it is negative. The managers have opted for a significant use of leverage to meet the requirements of shareholder value (valuation of the company vis-à-vis shareholders).

The Risks of Leverage

However, the leveraged transaction has risks that are often mitigated by the use of non-recourse financing. The latter may be the result of conventional arrangements or indebtedness of an ad hoc company. It should be noted that the leverage effect considerably increases the profits obtained thanks to the profitability of an asset (gain). Indeed, during the period of asset value growth, it offers an interesting efficiency. However it is imperative to know that any institution that has a leverage of between 30 and 1 sees its equity removed and the value of its assets decreased by 3.3%.

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