Leverage calculation: how is it done?
Making money on the stock and financial markets is often a feat, the result of skill, a pinch of luck, but also a shrewd strategy. Have you guessed what we are talking about today? Of... financial leverage!
The famous mathematician and geometer 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 wasn't 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 company, it can be crucial for Appvizer's audience.
In this article, we will explain what it is and explain 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.
The increase in the financial capacity of investors occurs through the use of a broker. The latter, in fact, will enable the company to come into possession of more liquidity: it will provide more money than it actually has available .
The broker thus plays the role of an intermediary who lends the money necessary for the company to gain a position in the market while having a minimum investment capital at its disposal.
Put simply, the calculation of leverage allows you to know to what extent you can indebt your company: you can, therefore, sell and buy financial assets for more than the capital the company actually has.
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 granted you.
As they would say across the Atlantic, '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 granted, so you are both winners!
The advantages 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, as you are relying on more capital than you actually have. Therefore, always try to use it correctly and wisely.
What is leverage used for?
Leverage is a tool for increasing the degree of exposure in the market following a small investment. In fact, only part of the total investment sum is invested, while the rest is made available by the broker.
The leverage mechanism allows the firm to suffer losses or accumulate relative profits, i.e. losses or profits that will be realised 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, the most important of which is the type of market in which it is employed (whether liquid or volatile).
The margin may be fixed or calculated as a percentage of the position value, depending on each particular case.
Leverage makes it possible to assess the ratio between equity and debt capital. This allows one to be more confident in choosing one source of financing 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 the latter that they are able to obtain income that exceeds the cost of the interest to be paid on the debt.
- Internal, when using equity, i.e. the company's own resources.
☝ External financing is used when the profitability of equity is to be improved.
The use of corporate debt
Companies use external sources of financing, i.e. debt, because these are generally cheaper. Indeed, the cost of third party capital (from banks or other lenders) is generally lower than that of venture capital, especially if long-term debt is involved.
Moreover, debt normally generates a certain tax advantage, since the financial charges, i.e. interest expenses, can be deducted from the pre-tax profit when drawing up the annual balance sheet. This results in a lower final tax amount and, thus, an increase in the value of the company.
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 financial charges borne by the company in order to receive financing will also be correspondingly high.
Thus, an increase in the value of the leverage ratio is expressed in an increase in financial charges. Indeed, as we have seen, higher interest rates intervene in this case. But it must also be considered that the charges themselves are calculated on a broader basis.
From these latter considerations, it is easy to deduce that leverage can show some substantial risks: if its value is very high, there is a risk that the company will go bankrupt if the investment does not pay off.
For this reason, it is only worthwhile for a company to opt for leverage for investment purposes if the expected return from the investment is greater than the sums received in debt.
How does leverage work?
Leverage works on the basis of a broker making a certain amount of credit available to the company making the investment, thanks to which more liquidity will be available for investment. Normally, the whole process takes place through the mediation of a trading software.
Leverage has specific effects: if the leverage effect is high, financial markets are made more accessible to investors, especially those with limited capital.
Leverage can be used on most markets: shares, 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 balance sheet and, in particular, the sources and uses item.
In fact, the calculation of leverage is the ratio of the amount invested to the capital held. In other words, it is necessary to divide total liabilities, i.e. the total sum of financing sources, by equity capital.
👀 The higher the leverage, the higher the return.
Leverage can therefore be calculated by applying the following formula:
Financial leverage = amount invested (current liabilities + fixed liabilities) / equity - shareholders' equity
Thus, the value of leverage varies depending on 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 leverage effect.
Caution! Several indices can be used to measure leverage, not just one. There is leverage 1 to 10, 1 to 100, 1 to 50, 1 to 2, and so on.
If, by calculating leverage, you get high values, 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 undercapitalised, i.e. that it has more debt (i.e. obligations to repay) than equity.
If leverage, on the other hand, is low, it means that the company has access to little financing. In turn, this means that equity exceeds debt, which translated can be interpreted as little risk and little return for the company.
Thus, the level and value of leverage is not always the same, but changes from trade to trade depending on 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 with the help of certain brokers, simply by paying a small part, a margin, of the entire sum. All this while maintaining a degree of total exposure.
Let us assume that:
→ The initial margin requirement is 10% of the whole sum, then you will have a total margin of EUR 10,000.
In the event of:
→ Increase in the share price, e.g. from 1 (assumed initial price) to 2 euro, you will make a duplicate profit, even though you have only paid part of the entire share price.
Leverage calculation on shares
The calculation model we have just seen was performed on an example of an investment on stock markets, i.e. an investment involving the purchase of shares.
Stocks are actually the most popular instruments for CFD (Contract for Difference) traders . In fact, CFD brokers are generally those who allow trading in the largest shares.
☝ It is important to remember, that through CFDs it is possible to trade in different financial instruments. These include cryptocurrencies, currency pairs (forex), stock market indices, commodities, etc.
Benefits and risks of leverage
It might seem that leverage is all about advantages. In fact, as we have just seen, through this mechanism it is possible to make a maximum profit while investing only a small part of the total sum 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, suffers a loss, this too will be considered in its entirety. The loss, like the gain, will, in fact, be related to the total result from the investment, not just the percentage actually invested by the company, i.e. the initial deposit. The investor should always keep the leverage indicator at bay, because while it can be a source of major benefits, it can result in major losses for the company. It is therefore of paramount importance to make proper and conscious use of leverage in order to reap maximum benefits. The biggest risk concerning leverage comes from credit institutions, i.e. banks. Whereas several years ago the bank was constantly trying to monitor and keep a credit granted until 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 do nothing more than cede their debtors to others. This operation allows them to recover the liquidity they need in a minimum time frame and to be able to reuse it as a credit offer for a new customer.
So, it can be said that leverage does not only amplify profits, which can be very high, but also potential losses. The latter can even exceed the amount invested, i.e. the initial deposit, in the event of particularly unfavourable markets.
Also to be kept in mind is the fact that brokers apply what is called a 'margin call': a margin call threshold is set lower than the margin actually used for the transaction. Thus, should the loss of your position exceed this threshold, the trade is automatically closed.
If you are a lover of Hollywood cinema, you can understand the concept in a playful way by watching the film "Margin Call": the film retraces the themes we have encountered in this article 😆
Don't worry, there are numerous opportunities in the online trading market to avoid large risks of loss. One such solution is the ' stop loss'. This is an automatic assessment of the risk of loss even before you open a trade: in short, you decide from the outset how much you are willing to lose.
Once the predetermined level is reached, the trade is closed, thus preventing you from suffering further losses.
Despite all these aspects that may seem negative and discouraging, leverage, if monitored properly, also brings other advantages, such as:
- The availability of greater liquidity, since it allows only small amounts to be invested;
- Better equity management (allowing diversification of investments);
- Broadening investors' market exposure .
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 to increase investors' exposure on various markets.
And you, have you ever made an investment using leverage? If so, please share your experience with us in the comments section below! Otherwise, feel free to share any doubts or uncertainties with us: the answers provided by our staff may help you!
Article translated from Italian