Financial leverage is an investment mechanism based on indebtedness, that is, it is the method used by many companies when investing in a business: they contribute a part of their own capital and the other part, through loans acquired from third parties. These types of strategies can be beneficial if everything happens as expected, however the risk involved can be much greater.
The basic element within what financial leverage means is debt, since it allows the investment of more money than you actually have, thanks to the proceeds of loans, in exchange for interest. One of the purposes of this method is to be able to increase the profits of the company, using borrowed funds.
Financial leverage can be: positive, negative or neutral.
It will be positive when the acquisition of funds from loans is profitable, ie the performance achieved on the assets of the company is greater than the amount of interest to be paid by the capital obtained from the loans.
It will be negative when the funds obtained through loans are unsuccessful, that is, when the profitability achieved on the company's assets is less than the interest that must be paid on the loan.
Finally, the leverage will be neutral, when the funds obtained through loans are in equilibrium, that is, the profit achieved on the assets of the company is equal to the amount to be paid for interest.
For the company, financial leverage could be a somewhat risky way to increase capital, since it runs the risk of being unable to meet payment commitments. Originating serious consequences for the company. So it is important to analyze its disadvantages:
The effect of leverage can generate losses, since if the company goes through a bad economic streak it will not be able to pay its debts. Another point to take into account is the risk perceived by future investors, since a company that is heavily in debt will not be attractive to those who want to invest in it, even when it is very successful.
