Financial leverage refers to the use of borrowed money (debt) to finance the purchase of assets with the expectation that the income or capital gain from the new asset will exceed the cost of borrowing. Companies use financial leverage to increase their asset base and generate returns on equity.
Leverage can enhance returns to equity holders, but it also comes with risks. The increased potential for higher returns comes with the cost of higher interest payments. And when a company has high financial leverage (meaning a lot of debt), it must generate enough cash flow to meet its debt obligations. If it doesn’t, it could face bankruptcy. So the use of leverage is a balancing act between risk and return.
The degree of a company’s financial leverage can be measured with ratios like the debt-to-equity ratio (total debt / total equity) or the equity multiplier (total assets / total equity).
It’s important to note that while financial leverage refers to the use of debt, the term “leverage” in a broader sense can also refer to any technique used to multiply gains and losses, such as the use of derivatives in a portfolio.
Example of Financial Leverage
Let’s take an example of a small business to illustrate the concept of financial leverage:
Suppose there’s a small business owner, John, who owns a coffee shop. His coffee shop is doing well, and he wants to expand his business by opening a second location. However, he doesn’t have enough cash on hand to finance the expansion.
So, John decides to borrow $100,000 from a bank. He uses this loan to open a second coffee shop. This is an example of using financial leverage—John is using borrowed money to try to increase his profits.
Let’s say that one year later, the second coffee shop is successful and has generated an additional $130,000 in profits after paying all the operating expenses but before paying interest on the loan. Suppose the interest owed on the bank loan for the year is $10,000. So after paying this interest, John’s net increase in profits due to the expansion is $130,000 – $10,000 = $120,000.
In this case, John’s use of financial leverage has indeed increased his profits. But this strategy was not without risk—if the second coffee shop had not been profitable, John would still have been on the hook for paying back the bank loan. This example demonstrates the potential rewards and risks that come with using financial leverage.