Leverage refers to the disproportionately strong influence of debt capital on the return on equity.
If, for example, the effective interest rate on a loan is lower than the interest rate on the capital market, the profitability of the investment can be increased with borrowed capital that is reinvested on the capital market (positive leverage effect).
However, leverage also entails risks. A negative leverage effect occurs when the difference between the return on total capital and the interest on borrowed capital becomes so great that the losses incurred can no longer be borne by the company. In this case, too much debt can lead to the company getting into financial difficulties and, in the worst case, even having to file for insolvency.
It is therefore important to keep an eye on the ratio of equity to debt and to choose an appropriate capital structure. Too much debt may lead to higher returns in the short term, but it carries a higher risk in the long term. It is therefore important to find a balance between equity and debt in order to take advantage of the opportunities of the leverage effect while minimising the risks.
It is important for investors to look not only at returns when selecting companies, but also at the capital structure. High debt can be a warning signal and indicate higher risk. Therefore, investors should always keep an eye on the ratio of equity to debt and consult an expert if necessary in case of uncertainty.
