The Degree of Leverage is the ratio between the indebtedness of a company and its own resources. Taking into account the profitability of recent years.
What is the Degree of Leverage?
Leverage is the strategy used by companies to produce higher returns on investment using loans or any other instrument.
This Leverage can be positive or negative, since, if you acquire an investment that makes you lose money, you will be facing a negative Leverage, while, if you acquire investment for X money, and you manage to sell it at twice what it cost you, You will be increasing profitability by 50%, and, therefore, it will be a positive Leverage.
Therefore, the Degree of Leverage will measure the relationship between the liabilities of a company and its own resources. So that the higher this Degree of Leverage, the greater the risk.
When we have a high Degree of Leverage we could obtain many gains or many losses.
As we can see, this concept tells us how to increase investment capacity through credits or fixed costs, which will function as a lever.
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There are two types of Leverage, which are:
Financial leverage: within this type, we can find the positive and the negative, let’s see some examples,
Suppose we buy a property that is worth 60,000 euros, but we only have 10,000 euros, then we ask the bank for the 50,000 euros that we need to buy it, the bank lends it to us, and, we manage to be owners of a property valued at 60,000 euros when only we had 10,000 euros, this would be the positive financial leverage.
Suppose that we invest in stocks and that we lose in said operation. This would lead us to lose more than invested, hence the negative financial leverage
Operating leverage: refers to obtaining maximum profitability in our processes and operations. For example, we could use technologies to our advantage such as the internet.
While an example of negative leverage, it would be not generating enough profits to have to pay for a system of our company, that is, to put money from another party.