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Advantages and Disadvantages of High Leverage Ratios for Financial Institutions

Essay by   •  June 1, 2012  •  Essay  •  263 Words (2 Pages)  •  4,774 Views

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Outline the advantages and disadvantages of high leverage ratios for financial institutions as below :l

everage is a way to use funds whereby most of the money is raised by borrowing rather than by stock issue for a company or use of capital by an individual. Leverage is considered an element of riskiness because it increases the volatility of expected net returns.

The leverage ratio is used to calculate the financial leverage of a company. This information gives an insight into the company's financing methods, or it can be used to measure the company's ability to meet its financial obligations.

One of the advantages by using leverage is to enable an individual or company to gain access to larger capital sums to make investments, with the aim of making a profit by doing so, especially when the lending interest rate is low in the market.

Besides, strateghies in leveraging run from basic to highly sophisticated, and the degree of risk varies in the same way. The benefits of leveraging will depend on the financial situation, objectives and the attitude to risk.

However, anything that has the potential make money involves some risk. High leverage which can make gains can be better than normal, losses can be worse. A change in interest rates can have an effect on your profit too. There is a risk that your investment will not make enough profit to pay off the interest on your loan.

The worst situation is high leverage ratio of a company is once the investment goes wrong, the debt becomes deprived of the capital and the company may face bankruptcy.

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