What is Financial Leverage?
Financial leverage refers to the use of borrowed funds (debt) to increase the potential return on investment. It allows businesses and investors to amplify their profits by using external financing rather than solely relying on their own capital.
Key Aspects of Financial Leverage
- Debt Utilization – Companies borrow money through loans, bonds, or credit to expand operations or invest in growth.
- Leverage Ratio – Measures the proportion of debt in a company’s capital structure. Common ratios include:
- Debt-to-Equity Ratio (D/E) = Total Debt / Shareholders’ Equity
- Interest Coverage Ratio = EBIT / Interest Expense
- Profit Enhancement – If the return on investment is higher than the cost of debt, leverage increases profitability.
- Risk Factor – Higher debt means increased financial obligations, which can lead to losses if earnings decline.
Advantages of Financial Leverage
✅ Higher Returns – Magnifies profits when investments perform well.
✅ Tax Benefits – Interest expenses on debt are tax-deductible.
✅ Business Expansion – Helps companies invest in new projects, acquisitions, or infrastructure.
Risks of Financial Leverage
⚠ Increased Financial Risk – High debt can lead to liquidity issues during economic downturns.
⚠ Potential Bankruptcy – If debt obligations exceed cash flow, companies may default.
⚠ Market Volatility Impact – Stock price fluctuations can affect leveraged firms more severely.
Example of Financial Leverage
- A company with $10 million in assets and $4 million in debt has a D/E ratio of 0.4. If the company earns higher profits than the debt cost, shareholders benefit. But if earnings fall, debt repayments can strain financial stability.
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