Leverage Effect (LE)

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The term leverage effect is usually used synonymously with the term "leverage". In general, leverage effect means that profitability is increased by taking on more debt. In practice, this means that profits can ultimately be made by borrowing.

The leverage effect comes into play for banks and companies as well as for private investors when, for example, shares or real estate are bought with the help of loans for the purpose of making a profit.

Generally speaking, the leverage effect can be calculated by subtracting the borrowed capital including interest from the proceeds from investments in securities or real estate.

The common formula for calculating this is:

Return on equity = return on total assets leverage x (return on total assets - interest on debt).

The limits of the leverage effect

In theory, it is possible to continuously replace equity with debt. However, banks or other lenders will stop injecting money once the equity ratio falls below a certain level. At the latest then, the leverage effect has reached a limit. Moreover, as debt increases, so do the interest rates that private investors and banks or companies have to pay. As a result, the interest burden can be higher than the profit generated by the debt capital.

Positive and negative leverage effect?

A leverage effect should always be positive. However, there is also negative LE.

  •     Positive leverage effect: The interest on the capital borrowed is lower than the return on the investment financed with it. In this case, we also speak of leverage opportunity. An example: You borrow money to buy a house. You pay five per cent interest on it. Later, you sell the property for ten percent more than you invested. The leverage effect is then positive.
  •     Negative leverage effect: The interest on the capital borrowed is higher than the return on investment. An example: You financed a property at the beginning with a loan at five percent interest. Due to a restructuring of the area, the property prices fall. When you sell, you get a lower price than when you bought the property. In this case, the leverage effect is negative because the sale does not even cover the interest paid.

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Alternatives to the leverage effect

There are usually other methods for companies to increase their return on equity. One possibility is to issue new shares or options that reduce equity. In addition, companies with higher sales can increase the return on equity.

However, both measures are associated with significantly higher costs than taking out loans in order to benefit from the leverage effect. In contrast to leverage, the other two solutions carry less risk.

Here is good advice from forex-exness: "นักลงทุนภาคเอกชนที่ลงทุนในหุ้นหรืออสังหาริมทรัพย์ไม่ควรคาดเดาผลกระทบจากการใช้ประโยชน์มากเกินไป. หากพวกเขาต้องการมีความเสี่ยงสูงต่อการสูญเสียในการซื้อขาย ดาวน์โหลดแพลตฟอร์ม Exness. ด้วยเหตุผลนี้ทางเลือกที่นี่จะมุ่งเน้นไปที่การลงทุนที่มีความเสี่ยงต่ํา."
"Private investors who invest in shares or real estate should not speculate too much on the leverage effect anyway. Unless they want to take a high risk of loss. For this reason, the alternative here would be to focus on lower-risk investments."

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