What is Leverage?

Every company that expects to make a profit needs money to run its operations. It is a simple rule: the more money you invest into a business, the higher the potential to make a profit. So, if you’re considering taking out a loan to support your business, you’re already considering leverage.

Leverage is a tool for both investors and corporations. It is especially useful for small businesses and startups with limited resources and assets. Even though there is a significant risk, it is still worthwhile to take the risk.

But what exactly is leverage, and how does it function? Read on to find out.

Understanding Leverage 

You can finance your company with small business loans or business credit cards. Leverage is nothing more or less than investing with borrowed funds. It’s an investment technique that involves employing loans—in the form of various financial instruments or debt funds—to boost an investment’s potential return.

Businesses frequently utilise leverage to support their expansion. On the other hand, you can use leverage to purchase homes (in the form of mortgage debt).  Meaning you can use repurchases to employ leverage to fund anything from home purchase to stock market speculation.

You can use the loan as a cash source or invest it to build an asset base and receive risk capital returns.

Just know that whenever you hear that a firm or investment is described as “highly leveraged,” it means that it has more debt than assets.

How Leverage Works

Using an example to explain how leverage works. Let’s say you own a small market and feel like expanding the business. According to the proposals, you will be renting new stores, interior decorations, shelving, tables, and other operational necessities. Also,  you will be needing more inventories as a result too.

Applying for a loan is one way to obtain funds. Leverage is all about getting the money you need to grow your business. It permits the company to do things it couldn’t do before because of the extra finances.

Leverage can be beneficial if you do not take on too much debt and you can repay it all.

Benefits of Leverage

The main advantage of leverage is that you can accomplish more with less, resulting in greater success in all areas of your life. It increases the returns on your financial investments, allowing you to grow wealth over time.

In the business world, leverage allows you to save time and money, discover new efficiencies, obtain new knowledge, become more efficient, increase productivity, achieve your objectives faster, and expand your company to new heights.

Again, leverage provides you full control and ownership of the business. When you use equity financing to fund your business operations, you must sell a portion of your company’s ownership. You can utilise leverage to boost your company’s returns on equity capital, especially if it is unable to improve its operating efficiency and overall investment returns.

Leveraging in trading

In recent times using leverage in trading has become increasingly popular, it is commonly used on CFD and Spread betting accounts, it allows the trader to leverage a higher amount, without owning the capital but reap the rewards of higher profit, the risk with this is when thing do not go your way, your losses can quite quickly develop.

A basic way of looking at how leveraging works in trading, is if you have an account with leverage such as 1:20 which is the highest eToro provide retail traders then if you want to invest £1000 then times that by 20 which gives you £20,000. So you would gain any profit or loss from that higher leveraged amount.

The good thing with accounts such as eToro and Trading 212 is they provide the user with balance protection, which means you can’t lose more than your balance in the account which is £1000, in this example. There are some accounts that do not provide this protection, so always check.

Conclusion

Leverage is a very useful tool to use when investing, it allows the trader to maximize their profits. Leveraging however would not normally be recommended for long-term trades.

When trading with CFD and Spread betting accounts you should always check their fees. Sometimes the fees may be significantly higher depending on what you’re trading.

Some links that may help you

Take a look at our free Financial Risk Calculator to find out what styles of savings and investments may suit you.

View our article on CFD accounts which can help you better understand the trading side of this article.