Financial Leverage

In finance, leverage is using given resources in such a way that the potential positive or negative outcome is magnified. It generally refers to using borrowed funds, or debt, so as to attempt to increase the returns to equity.

Financial leverage is the degree to which a business is utilizing borrowed money rather than equity to fund its operations. It reflects the amount of debt used in the capital structure of the firm. Debt is used to magnify the rate of return on shareholders' equity.

Financial leverage takes the form of a loan or other borrowings (debt), the proceeds of which are reinvested with the intent to earn a greater rate of return than the cost of interest. If the firm’s rate of return on assets is higher than the rate of interest on the loan, then its return on equity will be higher than if it did not borrow. On the other hand, if the firm's return on assets is lower than the interest rate, then its return on equity will be lower than if it did not borrow. Leverage allows greater potential returns to the investor than would otherwise have been available. Financial leverage is not always bad, However, financial leverage is not always bad; it can increase the shareholders’ return on their investment and often there are tax advantages associated with borrowing.

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