In the economic sphere, the definition of leverage is the strategy used to increase the profits and losses of an investment. Through credits, fixed costs or another tool at the time of investment, facilitate the growth of the profitability final, which can be positive or negative.
It should be clarified that a higher degree of leverage also represents a higher financial risk, since although the gains are considerably increased, the leverage effect can also lead to a greater amount of losses.
The concept of leverage comes from leverage, which is defined as lifting or moving something with the help of a lever. There is some similarity between the two terms, since leverage uses the fixed costs or debt as a lever to increase investment options.
Leverage consists mainly of using a company's indebtedness to finance an operation. Its main advantage is that it allows multiplying the profitability of a business and the most common problem is that the operation is negative.
Types of leverage
We are going to distinguish between two classes of leverage.
- Operating leverage- Use fixed costs to achieve higher profitability per unit sold. It is the relationship between fixed and variable costs used by a company in the production of goods.
- Financial appeceament: in this case the debt is used in order to increase the amount of money that can be dedicated to investment. Addresses the relationship between equity capital and credit used in a financial operation.
When a company makes an investment in equipment or machinery, it is using leverage, just as it is when it requests a loan to expand the business or to invest in stock. In the first case it would be operating leverage, while in the other two situations it would be financial leverage.