What is Financial Leverage?
Financial leverage involves using borrowed funds (debt) to acquire assets, anticipating that the returns will exceed borrowing costs, and aiming to enhance the return on equity. It is a strategy that companies use to multiply their gains (or losses), as the borrowed money ideally helps to generate more income than the cost of the debt itself. It finds application in real estate, stocks, and business expansion decisions. The decision to employ financial leverage depends on factors like expected returns, debt-handling capacity, and prevailing interest rates. While it can amplify returns, its excessive use may expose a company to significant risks, requiring a careful balance between its advantages and disadvantages.
Key Takeaways
- Financial leverage includes utilizing borrowed funds (debt) to acquire assets with the anticipation that returns will surpass borrowing costs, enhancing the return on equity.
- The pivotal aspects of financial leverage include leveraging debt for increased returns, heightened sensitivity to economic cycles, and the association of higher debt-to-equity ratios with elevated financial risk.
- Financial leverage is applicable in various sectors, such as real estate, stocks, and business expansion decisions.
- The decision to employ financial leverage depends on factors like expected returns, debt-handling capacity, and prevailing interest rates.
- Employing financial leverage requires a careful balance between its advantages and disadvantages.
Table of Content
- Why is Financial Leverage Important?
- Financial Leverage Formula
- How to Calculate Financial Leverage?
- Advantages of Financial Leverage
- Disadvantages of Financial Leverage
- Difference Between Financial Leverage and Margin
- Frequently Asked Questions (FAQs)