What is financial leverage and why is it important?
What is Financial Leverage?
Financial leverage refers to the use of borrowed money to finance investments or other financial transactions. It allows individuals and businesses to increase their purchasing power and invest more money than they would be able to otherwise. Calculating financial leverage can help individuals and businesses understand their level of borrowing and the potential risks and rewards of using leverage.To calculate financial leverage, you will need the following information:
- The total amount of debt that has been borrowed
- The total value of the assets that have been purchased with the borrowed funds
Once you have this information, you can use the following formula to calculate financial leverage:
- Financial Leverage = Total Debt / Total Assets
For example, let's say you have borrowed $80,000 to purchase a $100,000 house. In this case, the total debt is $80,000 and the total assets are $100,000, so the financial leverage would be calculated as follows:
- Financial Leverage = $80,000 / $100,000 = 0.8
This means that your financial leverage is 0.8, or 80%. This indicates that you have borrowed 80% of the total value of the assets that you have purchased.
It's important to note that the higher your financial leverage, the greater the potential risks and rewards of using leverage. A high level of leverage can lead to higher potential returns on your investments, but it can also lead to higher potential losses if the investments do not perform well. Therefore, it is important to carefully consider the risks and potential drawbacks of using leverage and to use it wisely.
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