Financial Leverage: Definition, How It Works, and How It’s Measured

What is Financial Leverage?

Financial leverage is the use of borrowed money to increase the capital a company can use for operations or to purchase assets. The goal of financial leverage is to earn a higher return on those investments than the cost of borrowing.

When financial leverage works as intended, it can amplify a company’s earnings and returns to shareholders. For example, raising capital through debt can help a business expand production capacity, update equipment, or fund initiatives that support higher revenue and profits. 

However, financial leverage comes with risks. Companies must meet obligations, such as monthly loan payments and interest charges, regardless of whether their financial performance improves or declines. If performance weakens, these obligations can put a business in financial distress if not managed effectively. 

This guide breaks down what financial leverage is, how it works, how it’s measured, and the risks associated with using it.

How Financial Leverage Works

When purchasing assets, three options are available to the company for financing: using equity, debt, or leases. Apart from equity, the remaining options incur fixed costs that are lower than the income the company expects to earn from the asset. In this case, we assume that the company uses debt to finance asset acquisition.

Financial Leverage Example

Suppose your organization wants to purchase a piece of machinery that costs $100,000. The company can use either equity or debt financing. 

If the company uses equity to purchase the machinery, it will own 100% of the asset and avoid paying interest. If the asset appreciates by 30%, its value will increase to $130,000. Similarly, if the asset depreciates by 30% to $70,000, the company will incur a loss of $30,000.

Alternatively, the company may opt to finance the purchase using 50% common stock and 50% debt. If the asset appreciates by 30%, its value will rise to $130,000. Assuming the company pays back the debt of $50,000, it will have $80,000 remaining. 

However, if the asset depreciates by 30% to $70,000, the company’s equity will decrease by $30,000 to $20,000, and it will still owe $50,000 in debt. 

How to Measure Financial Leverage

Financial leverage is measured using leverage ratios that compare a company’s debt levels to its equity, capital, or earnings. Each ratio provides different insights into a company’s leverage and risk profile.

Debt-to-Equity Ratio

The debt-to-equity ratio is used to determine the amount of financial leverage of an entity, and it shows the proportion of debt to the company’s equity. This ratio helps the company’s management, lenders, shareholders, and other stakeholders understand the level of risk in the company’s capital structure. 

You can calculate the debt-to-equity ratio using the following formula:

Debt-to-Equity Ratio = Total Debt / Total Equity (or Shareholders’ Equity)

Total debt, in this case, refers to all of a company’s interest-bearing liabilities, whether current (debts the company intends to pay within one year or less) or long-term (debts with a maturity of more than one year).

Equity refers to the shareholders’ equity (the amount that shareholders have invested in the company) plus the amount of retained earnings (the amount that the company retained from its profits).

Companies in the manufacturing sector typically report a higher debt-to-equity ratio than companies in the service industry, reflecting the higher amount of the former’s investment in machinery and other assets. Usually, the ratio exceeds the US average debt-to-equity ratio of 54.62%.

Other Leverage Ratios

Other common leverage ratios used to measure financial leverage include:

• Debt to Capital Ratio
• Debt to EBITDA Ratio
• Interest Coverage Ratio

While the debt-to-equity ratio is the most commonly used leverage ratio, the three ratios are frequently used by finance professionals in corporate finance to measure a company’s leverage.

Risks of Financial Leverage

Financial leverage creates three major risks: amplified losses, stock price volatility, and reduced borrowing capacity. 

Amplified Financial Losses

Although financial leverage may result in enhanced earnings for a company, it may also result in disproportionate losses. Losses may occur when the interest expense payments for the asset overwhelm the borrower because the returns from the asset are not sufficient. This may occur when the asset declines in value or interest rates rise to unmanageable levels.

Stock Price Volatility

Increased amounts of financial leverage may result in large swings in company profits. As a result, the company’s stock price will rise and fall more frequently.

Reduced Borrowing Capacity

When lending money to companies, financial providers assess the firm’s level of financial leverage. For companies with a high debt-to-equity ratio, lenders are less likely to advance additional funds since there is a higher risk of default. 

However, if the lenders agree to advance funds to a highly leveraged firm, it will lend at a higher interest rate that is sufficient to compensate for the higher default risk. 

Bankruptcy

In a business with low barriers to entry, revenues and profits are more likely to fluctuate than in a business with high barriers to entry. These financial fluctuations may easily push a company into bankruptcy since it will be unable to meet its rising debt obligations and pay its operating expenses. 

With looming unpaid debts, creditors may file a case at the bankruptcy court to have the business assets auctioned in order to retrieve their owed debts.

Operating Leverage

Operating leverage is defined as the ratio of fixed costs to variable costs incurred by a company in a specific period. 

If the fixed costs exceed the amount of variable costs, a company is considered to have high operating leverage. Such a firm is sensitive to changes in sales volume, and the volatility may affect the firm’s earnings before interest and taxes (EBIT) and returns on invested capital (ROIC).

High operating leverage is common in businesses requiring heavy equipment investment, such as manufacturing firms that need machinery to make their products. 

Regardless of whether the company makes sales or not, the company incurs fixed costs like depreciation on equipment, overhead on manufacturing plants, and maintenance costs.

The Bottom Line: Financial Leverage

Financial leverage allows companies to amplify returns by using borrowed money to acquire assets. But leverage can equally magnify losses when investments underperform. Leverage ratios help investors and analysts assess how much financial risk a company carries from its debt.

Financial leverage can help a business accelerate its growth and preserve cash. However, excessive debt can increase bankruptcy risk, limit future borrowing capacity, and create volatility in stock prices and earnings.

Frequently Asked Questions

What does financial leverage mean?

Financial leverage means borrowing money to purchase assets or fund operations, expecting the returns to exceed the interest costs. It allows companies to control more assets than they could with their own cash alone. This magnifies both potential profits when investments succeed and losses when they fail.

What is the financial leverage ratio?

Financial leverage ratios measure how much debt a company uses relative to its assets or equity. A common leverage ratio is the debt-to-equity ratio, which divides total debt by shareholder equity. Other leverage ratios include the debt-to-capital ratio, the debt-to-EBITDA ratio, and the interest coverage ratio. Each ratio provides different insights into a company’s debt levels and financial health.

Does higher leverage mean higher debt?

Yes, higher leverage means a company is using more borrowed money relative to its own capital. This shows up as higher debt levels on the balance sheet and higher debt-to-equity ratios. More debt increases both the potential for amplified returns and the risk of financial difficulty if investments underperform.

Additional Resources

Thank you for reading CFI’s guide to Financial Leverage. To continue learning and advancing your career, these additional CFI resources will be helpful:

Leverage Ratios

Return on Equity

Valuation Multiples

See all Accounting resources