Financial leverage

Definition

Financial leverage refers to the use of borrowed funds to increase the potential return on investment. By employing financial leverage, a company can amplify its profits from its investments; however, it also increases the risk as debt must be repaid regardless of the company's financial performance. Balancing financial leverage is crucial for making effective financial decisions, as it can affect the overall risk profile and financial stability of an organization.

5 Must Know Facts For Your Next Test

1. Companies use financial leverage to enhance their returns, but higher leverage also means greater risk, especially in downturns when revenues fall.
2. The optimal level of financial leverage varies by industry and company size, with some industries traditionally using more debt than others.
3. Interest payments on debt are tax-deductible, which can make financial leverage an attractive option for businesses looking to lower their taxable income.
4. Increased financial leverage can lead to higher volatility in earnings per share (EPS), which may affect investor perceptions and stock price.
5. It's important for companies to monitor their financial leverage carefully to avoid over-leverage, which can lead to bankruptcy or financial distress.

Review Questions

• How does financial leverage impact a company's risk and potential return on investment?
  • Financial leverage can significantly affect both the risk and potential return on investment for a company. By borrowing funds, companies can invest more than they would using only their equity, potentially leading to higher profits when investments perform well. However, this also means that if investments do not yield expected returns, the company still has to meet its debt obligations, increasing the risk of financial distress or bankruptcy.
• Discuss how interest rates influence a firm's decision-making regarding financial leverage.
  • Interest rates play a crucial role in a firm's decision-making process regarding financial leverage. When interest rates are low, borrowing becomes cheaper, encouraging companies to take on more debt to finance growth and expansion. Conversely, high-interest rates increase the cost of borrowing, which may deter firms from using leverage and lead them to rely more on equity financing instead. This relationship affects overall capital structure decisions and can influence corporate strategy.
• Evaluate the long-term implications of excessive financial leverage on a company's growth strategy and overall sustainability.
  • Excessive financial leverage can have detrimental long-term implications for a company's growth strategy and sustainability. While it may provide short-term boosts in profit margins and cash flow, high levels of debt increase vulnerability to market fluctuations and economic downturns. If a company becomes over-leveraged, it may face challenges in securing additional financing for future growth or investing in innovation due to high debt obligations. This situation can ultimately hamper strategic flexibility and lead to reduced competitiveness in the long run.

Related terms

debt-to-equity ratio: A financial ratio that compares a company's total liabilities to its shareholder equity, indicating the proportion of debt used to finance the company's assets.

cost of capital: The required return necessary to make a capital budgeting project, such as building a new factory, worthwhile. It includes the cost of debt and the cost of equity.

return on equity (ROE): A measure of a corporation's profitability that reveals how much profit a company generates with the money shareholders have invested.