On Using Leverage

One thing to be mindful of when borrowing or obtaining a credit is if the debt being incurred is a good or a bad debt.

Borrowing and incurring debts is generally perceived to be bad. For many cogent reasons, debt is especially marked as a lack of financial discipline. However, history is replete with stories of businesses – past and present that have leveraged their ways to success.

On a micro level, not everyone can afford to outrightly pay for their lives’ essentials such as getting a home, car, education etc. Loans come in handy to ease the financial pressure while ensuring the present needs are met.

However, the thing to be mindful of when borrowing or obtaining a credit is if the debt being incurred is a good or a bad debt.

When an individual buys a luxury item for personal use, it may not yield an income. It is okay if such an item was purchased from an interest-free loan but is bad if it is the otherwise.

One the other hand, borrowing funds to buy an asset or to invest is valuable especially when the capital and interest can be repaid with the proceeds of such an investment. This is what leverage is about.

Leverage talks about using borrowed capital for an investment with the expectation that the profits made are greater than the interest payable. Note that bad debt is incurred when an individual purchases items with such funds that depreciate in value and do not generate income given the fact that debt carries its interest rates, while good debt is one incurred as an investment that is capable of growing in value to generate profit.

Obtaining credit or loans for an investment to amplify returns is referred to as leverage. Profit is made if the return on an investment financed from borrowed funds is higher than the principal and interest rate.

The important thing here is that the item (asset) invested on, should generate enough income or create sufficient equivalent value necessary to pay the debt at the least and to generate profit.

Many investors use leverage to increase their portfolio as funds borrowed can be used to increase returns and other investment capital. Companies also use leverage to finance their assets and scale up their operations as an alternative to turning to the stock market in search of funds.

While leverage can magnify profit by increasing the volume of the investment, it can also have exactly the same multiplier effect on losses when possible investment goes bad especially where the value of the debt exceeds the income generated by an asset as well as where the value of the asset falls.

Warren Buffet has been investing in stocks for decades. He hit a goldmine by purchasing his way into the insurance business and made strategic investments on stocks of other companies from the large investment funds that the insurance company controlled which generated a significant multiplier compared to the funds he spent on purchasing the insurance company.

However, his amazing investment record was largely dependent on his making the right investment at the right time. Consequently, no financial strategy (including the use of leverage) can work by itself without sound investment or financial education.

Written by Lawretta Egba.