Okay, I know basic math and I see the numbers, but I’m an economic idiot because I fail to see how taking bigger loans cause higher profits. What is the leverage effect and why do I want to make use of it?
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Let’s say I’m really really good at making lemonade. The best in fact. I can sell this stuff for $5 a bottle. But.. I have a problem. I don’t have the money to buy lemons.. or sugar..
So.. I go to the bank and ask the nice person at the bank for $100 so I can go buy some lemons and sugar so I can make that amazing lemonade. We agree that in a few months I’ll pay the bank back it’s $100, as well as a $10 fee since they were nice enough to loan me the money in the first place.
A few months go by, I bought the lemons and the sugar and got to selling. And it’s a hit! I completely sold out of lemonade almost immediately. I sold so much lemonade I made $1000! Holy crap!
I then go back to the bank with my $1000 and give them their $100 plus the $10 fee and pocket the rest. Such a good deal!
The thing is, in this situation because my lemonade was so popular, if I took out a $200 loan I could have bought more lemons and very likely could have made $2000 instead of $1000 and doubled my revenue.
That’s the basics of leverage. You borrow money and then use that to make more money by investing it into something else. In this case, I invested the money into my own skills into making lemonade. But that could be anything. A house, a business etc..
EDIT: I should point out that this isn’t risk free. If I happen to sell no lemonade, then, I owe the bank their $100 back along with their $10 fee. In this example the numbers are small but imagine this when you’re taking about borrowing millions of dollars and the risk becomes more apparent.
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