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Financial Leverage

 

Financial Leverage: The use of borrowed money (debt) to amplify potential returns on investment, but also potential losses.

Financial leverage refers to the use of borrowed funds to finance the purchase of a company's assets. It is a measure of the extent to which a company relies on debt financing as opposed to equity financing.

Key points to understand about financial leverage are:

  1. Nature: Financial leverage involves using debt to finance company operations, with the aim of enhancing potential returns to shareholders. When a company leverages, it essentially borrows money to invest in business growth, hoping that the returns from the investment will exceed the cost of the debt.
  2. Examples: Taking on a loan to purchase new equipment, issuing bonds to fund expansion, or using credit lines to finance inventory purchases are all examples of how businesses employ financial leverage.
  3. Implication on Profitability: Financial leverage can significantly impact a company's profitability. If the return on assets financed by the debt is greater than the interest cost of the debt, financial leverage can increase a company's earnings. However, if the return is less than the interest cost, earnings may decrease.
  4. Risk and Reward: While financial leverage can enhance potential profits, it also increases the risk. The higher the degree of financial leverage, the higher the risk, as the company must meet its debt obligations regardless of its financial performance.

Understanding the concept of financial leverage is critical in corporate finance and accounting as it helps businesses make informed decisions about financing strategies and risk management. It has significant implications for a company's balance sheet, profitability, and risk profile.