Using “other peoples’ money” sounds like a great way to make a fortune. Borrow some money, make a fortune, pay back your lender, and keep the rest. What could be better?
Archimedes is credited with establishing the concept of leverage, over 2000 years ago. He famously stated that, given a lever long enough and enough distance, he could lift the earth.
In “On the Equilibrium of Planes” Archimedes wrote: “Magnitudes in equilibrium at distances are reciprocally proportional to their weights.” However, the Peripatetic School (the followers of Aristotle) wrote of levers before the birth of Archimedes.
As a verb, to leverage means to gain an advantage through the use of a tool. For example, you can more easily lift a heavy object with a lever than you can lift it unaided.
Leverage is an idea which humans have used to great effect for thousands of years, enabling them to gain disproportionate strength. For example, the ancient Egyptians used levers to lift stones weighing up to 100 tons in order to build the pyramids and obelisks. Many of humanity’s tools, used for centuries all over the world, incorporate levers- scissors, pliers, door handles, wheelbarrows, fishing rods and more.
Leverage in the financial context is an investment strategy of using borrowed money — specifically, the use of various financial instruments or borrowed capital — to increase the potential return of an investment.
Leverage can also refer to the amount of debt a firm uses to finance assets. Leverage helps you buy an investment asset with somebody else’s money. Once your loan and interest has been repaid, your investment asset keeps working for you and can provide you with an income source or passive income for a long time.
Leverage is a form of financial amplification-it magnifies the potential for both gains and losses. When your investment pays off, leverage helps it pay off more. However, when your investment tanks, you lose more money than you would otherwise.
One of the major contributing factors of the recession of 2008 / 2009 was the use of enormous amounts of leverage by investment banks. It wasn’t uncommon for banks to leverage their investments by a factor of 30-40. Millions (or billions) of dollars were made or lost when the value of a particular stock went up or down by a single percentage point. When the market crashed, the bank’s losses were magnified by the amount of leverage they took on, which was more than enough to threaten their existence.
Using Leverage can be like playing with fire; it can be a useful tool if used properly, but it can also burn you severely. Never use leverage unless you’re fully aware of the consequences and are prepared to accept them. Otherwise, you will end up putting your business and personal financial situation at risk.
Positive leverage is that debt which multiplies your money by putting money into your pocket, while negative leverage is that debt which reduces your money by taking money out of your pocket.
Contrary to popular opinion, positive leverage is not risky, if you know how to harness its power. In fact, lack of proper leverage may hinder or delay your goal of achieving financial independence.
You should learn to harness the power of positive leverage so as to multiply your money and wealth; but you should never try to over leverage, whether you are dealing with your life or your money. Normally, it is greed, which leads to over leverage, and greed is the biggest enemy and the most harmful emotion over which normally most people have no control.
The Golden rule for financial leverage is that Debt should be used to buy Investment assets and not consumption items or negative income ‘assets” Debt should never be used to do unnecessary revenue expenditure and spending on luxuries. Credit card debt is the most common example of this kind of leverage.
If you use leverage to buy investment assets, it will provide you with passive income but if you use leverage to buy liabilities disguised as accounting assets, it will result only in your liabilities multiplying to give you lifelong costs in the form of maintenance and other running expenses. Therefore, leverage or debt should be used to buy only and
only investment assets.
Positive leverage is that debt which multiplies your money by putting money into your pocket, while negative leverage is that debt which reduces your money by taking money out of your pocket.
While using financial leverage, you have to ensure that your Return on investment should be more than cost of capital so as to provide you positive leverage. There are several ratios to assess the financial health of a business. One of the key financial ratios in use to determine the amount of financial leverage in a business is the debt/equity ratio which shows the proportion of debt in a business to equity. Next comes the DSCR, or the Debt Service Coverage ratio which refers to the amount of cash flow available to meet annual interest and principal payments on debt and is used to determine debt servicing ability.
Next comes the liquidity ratios primarily the current ratio that measures a company’s ability to pay short-term obligations or those due within one year.
Finally metrics that evaluates how efficiently a company’s available capital is utilized are evaluated using ratios like ROCE (Return on Capital employed) and the ROA(Return on Assets).
The purpose behind the evaluation is to determine whether a business or individual is using positive leverage or negative leverage. Negative leverage in a downturn or a competitive market scenario when the margins get squeezed can prove disastrous.
Similarly leverage for speculative purposes may prove lucky when the going is good and may magnify profits but when greed takes over and the tide turns, it may wipe out your entire capital. Margin trading and trading in futures and options by part time traders have had disastrous consequences for most people due to this reason.
We mostly hear the word “leverage” used when discussing financial concepts like investment and debt but the simple concept of “leverage” also has the power to get you more time, better fitness, career or business success, financial control and relationship satisfaction.
Because leveraging means to expand rewards for every outlay, this term can apply to all kinds of concepts beyond debt and investing. You can leverage your time by delegating more and thereby getting more done in the same timeframe.
Sports persons and Celebrities regularly leverage their achievements by bagging multi million dollar endorsement deals due to their celebrity status and fan following.
People do extensive networking so that they can leverage their connections to get breakthroughs, to win contracts, to get entry into elite groups and to learn new skills.
The biggest leverage tool all humans can possess is knowledge. If you can strengthen this leverage, you can unleash the power within you to expand the boundaries, be it of wealth or happiness or accomplishment. Knowledge helps you to even the odds and reduce the risks, because risk is nothing but what is unknown.
Thus, what really matters in the end is when you leverage your knowledge, talent and skill to grow and achieve success. Not everyone who is talented or has knowledge is a success. You need to leverage it with persistent effort and get the right breaks to transform your talent into success.
Contrary to popular opinion, leverage is not risky if you know how to harness its power. In fact, lack of proper leverage may hinder or delay your goal of achieving financial independence.
Despite the benefits, however, most of us don’t utilize the power of leverage as much as we could. Begin to maximize your potential today, by leveraging the tools you already have at your disposal to achieve success.
Happy Investing!
Stay Blessed Forever
Sandeep Sahni
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Note: All information provided in this blog is for educational purposes only and does not constitute any professional advise or service. Readers are requested to consult a financial advisor before investing as investments are subject to Market Risks.About The author
Sandeep Sahni
Sandeep is an alum of IIM Lucknow with a Post Graduate Degree (MBA class of 1988). His also an alum of Shri Ram College of Commerce, Delhi University (B.Com. Hons. Class of 1985.)
Sandeep’s investing experience and study of the Financial Markets spans over 30 years. He is based in Chandigarh and has been advising more than 500 clients across the globe on Financial Planning and Wealth Management.
He has promoted “Sahayak Gurukul” which is an attempt to share thoughts and knowledge on aspects related to Personal Finance and Wealth Management. Sahayak Gurukul provides financial insights into the markets, economy and Investments. Whether you are new to the personal finance domain or a professional looking to make your money work for you, the Sahayak Gurukul blogs and workshops are curated to demystify investing, simplify complex personal finance topics and help investors make better decisions about their money.
Alongside, Sandeep conducts regular Investor Awareness Programs and workshops for Training of Mutual Fund Distributors, and workshops and seminars on Financial Planning for Corporate groups, Teachers, Doctors and Other professionals.
Through his interactions and workshops, Sandeep works towards breaking the myths and illusions about money and finance.
He also writes a well read blog;
He has also conducted presentations, workshops and guest lectures atManagement institutes for students on Financial Planning and Wealth Creation.
He can be reached at:
+91-9888220088, 9814112988
sandeepsahni@sahayakassociates.com
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