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financial leverage

Financial Leverage – Tool for Accelerated Wealth Creation

Leverage is simply borrowing money to purchase investments, with the goal of achieving greater wealth.

Investment leverage, is borrowing to invest. We can utilize our resources and assets to acquire good debt (an investment debt that creates value), then we can expect exponential growth on our money. It is using someone else’s money to achieve your investment goals.

With traditional investing, you set aside a portion of your income each month to purchase investments and your investments gradually grow over a long period of time. With leveraged investing, you take out a loan and make a single large investment purchase on day one. Then, you set aside a portion of your income each month to make interest payments on the loan.

Example One: If you have cash on you, you can buy your own house fully paid for on cash. Say the house costs USD100 000 and you pay the full value. Suppose it appreciates in value and four years later you sell it for $150 000. So you made a profit or return on investments of $50 000 out of your original $100 000. That is a gross return of 50%. Now suppose you buy the same house using mortgage with a 20% down payment. It means you pay $20 000 of your own money to get a $100 000 house. Suppose you now sell the house at $150 000 four years later. You repay the loan ad interest say at $80000 loan and $20 000 interest. Your profit out of your initial investment of $20 000 is $30 000 which is 150% return on your initial investment. That is leverage. You get a better return on your funds faster. One could also use the balance of the $100 000 to get other investments. So anyone who gets a mortgage is using the principle of leverage.

Example Two: By leverage, we mean that the asset is being purchased with only a portion of the purchase price coming from the buyer and the balance coming from a lender. Suppose that the house in Example One was actually for rental purposes which means that the repayment is covered by the tenant. SO the tenant is paying for your house. In fact this is another form of leverage uses someone else resources to acquire you an asset. Therefore any increase in value of the entire house represents a real return on the original amount invested. In this theoretical case On selling the house you get a profit of $150 000 – $20 000 = $130 000. Since the $80 000 borrowed and its interest from bank is covered by the rentals. So your actual return on investment is about 650%. That is the power of financial leverage.

NB Obviously we have excluded other costs that will reduce the return on investments for simplicity like transfer fees, agency fees etc

Leverage is any technique that amplifies investor profits or losses. It’s most commonly used to describe the use of borrowed money to magnify profit potential (financial leverage), but it can also describe the use of fixed assets to achieve the same goal (operating leverage).

Example Three

A friend and I decided to develop some real estate and at that time felt that we could not access bank loans. So we decided to partner on acquiring the land. We opted to develop some cluster homes. But since the banks where not amenable to finance the project because of a illiquid market. We used two forms of leverage as follows: Initially we used little money to renovate the existing structures and produced three units which we then sold to generate the starting capital for the project. Once we started on the project we sold some units as they were under construction. These funds enabled us to complete the sold units and start on other units which we then sold as completed. This way we used leverage of the pre-purchasers to deliver the whole project. I have simplified this process for explanatory power but one has to be cautious and not be tempted to divert parts of the inflow to personal use but t ensure that one delivers the correct and promised value to the pre-purchasers.

Fourth Example: As an entrepreneur you can be self employed and use all your effort and energy to deliver value to your clients. You are using your own time and energy. But of one was to find a way of employing other people to deliver the value and compensate tem well one would be using the principle of leverage in multiplying one’s productivity by leveraging the time, skills and competences of the people one has hired.

So leverage can accelerate your path to financial destiny. However a closer look at these examples shows that leverage has both advantages and disadvantages, So one has to be careful. Tomorrow we look at advantages and disadvantages of financial leverage.

Financial Leverage: Refresher Course First

Understanding Investment leverage

“Give me a place to stand, and I shall move the earth with a lever”– Archimedes.  It is most likely an exaggeration but the point is that you can almost move impossible things using less force through the principle of leverage.

In this posting I refresh your minds on the Principle of leverage and then from tomorrow we apply it to wealth creation.

Leverage is defined as a small force placed in a strategic place that can bring extraordinary movement. It is a mechanical form of the principle of multiplication. In principle, a lever allows you to use less force to lift or move objects.

We may not know it, but this theory is applied in a lot of the everyday objects we use such as scissors, bottle openers and even doors. Lets look at simple classes of levers and how they occur in everyday life.

Classes of Levers

Class One occurs when the Fulcrum is located between Load and Effort. If the length of the effort arm is greater than the length of the load arm you use less force. The opposite is also true. The more leverage you have the less effort you exert to accomplish your goals.

A pliers is an example of class One lever. When I was a practising dentist I used to struggle with my staff because often when doing a difficult extraction you need a forceps with longer handles so that you apply effort to deliver a greater force BUT often they did not get it and so they would bring me a short handled forceps. This made me work harder to achieve the result.

In Class Two the Load is located between Effort and Fulcrum. In this case the length of Effort Arm is greater than the length of Load Arm; therefore, we use the least effort in the Class II lever. This is the best form of leverage.

In Class Three Effort is located between Load and Fulcrum. The length of the Load Arm is greater than the length of the Effort Arm; therefore, we use the most effort in Class III lever. So when you use this kind of leverage you work harder.

After this refresher course we realize that the principle of leverage is universal. We can apply the principle of leverage in everything that we do in our life. We can start on a personal level and leverage on our mind. When you invest in yourself through self development you use the principle of smart leverage. My father used to say, “If you do not use your head, your limps will suffer.” Put simply the less you think the more effort and hard work you put into your problems solving and wealth creation system. I would rather use leverage. The average African prefers to sweat to feel that he is working. The more fort spent the better they feel they have worked. We are learning slowly to use leverage and sweat less.

With regards to money, we can likewise use the principle of leverage to accelerate our financial goals. When properly understood and intelligently applied, leveraging will allow us to create more wealth less effort.

This is called financial leverage. In general, it simply means using other people’s money and making it work for us. The principle of leverage is probably the fountainhead of wealth.

When we simply rely on our own capability to save money, then it will take some time before we can invest and accumulate wealth.

Tomorrow I will give some practical examples of financial leverage in your wealth creation journey.