Why is debt financing referred to as financial leverage

However, if a company is financially over-leveraged a decrease in return on equity could occur. Financial over-leveraging means incurring a huge debt by borrowing funds at a lower rate of interest and using the excess funds in high risk investments. The most obvious risk of leverage is that it multiplies losses.

There is a popular prejudice against leverage rooted in the observation of people who borrow a lot of money for personal consumption — for example, heavy use of credit cards.

However, in finance the general practice is to borrow money to buy an asset with a higher return than the interest on the debt. On the other hand, when debt is taken on for personal use there is no value being created, i.

There is also a misconception that companies enter a higher level of financial leverage out of desperation, referred to as involuntary leverage. While involuntary leverage is certainly not a good thing, it is typically caused by eroding equity value as opposed to the addition of more debt.

Therefore, it is typically a symptom of the problem, not the cause. When evaluating the riskiness of leverage it is also important to factor in the value of the company itself and its activities. If a company borrows money to modernize, add to its product line, or expand internationally, the additional diversification will likely offset the additional risk from leverage. The upshot is, if value is expected to be added from the use of financial leverage, the added risk should not have a negative effect on a company or its investments.

Total leverage can be determined by a couple of different methods. If the percentage change in earnings and the percentage change in sales are both known, a company can simply divide the percentage change in earnings by the percentage change in sales. Another way to determine total leverage is by multiplying the Degree of Operating Leverage and the Degree of Financial Leverage.

Fully derived, we see that to multiply Degree of Operating Leverage and Degree of Financial Leverage, we subtract fixed costs and interest expense from the total contribution margin revenue minus variable cost times the number of units sold , and divide total contribution margin by this result.

It decides to take out a business loan to finance the growth it would like to achieve. Using debt financing from the loan, the company is able to hire two more employees, purchase top-of-the-line equipment, and contract a designer to create a billboard advertisement. The business owner predicts that if everything goes as planned, with these new assets the company will be able to install twice the number of swimming pools in the next year, doubling its profit while still paying interest on the debt.

Instead, it leveraged the loan money it borrowed to become a bigger, more profitable operation than it was before. Depending on the size of the company, businesses will sometimes take on hundreds of thousands of dollars of debt in order to leverage it and purchase assets.

Wondering how much debt you can leverage? Learn how to calculate cost of debt in our resource. Maddie is a former content specialist at G2. She also has a passion for music and cats. Explore Topics Expand your knowledge. Curated Content Your time is valuable. The shareholders of the firm would be able to get a significantly higher rate of return if the company decided to use leverage i.

The workout below shows how using leverage magnifies the returns for a company i. A word of caution: while the use of leverage may seem enticing from the point of view of shareholders of a company, it is a high risk proposition. Should a company take on too much debt i. Further, as stated above, if there are several years of losses, the company may not be able to survive the downturn in its businesses, due to the high level of interest payment commitments as a result of taking on too much debt.

There is a risk of bankruptcy if a company cannot service its debt commitments. Sign up to access your free download and get new article notifications, exclusive offers and more.

The use of debt financing referred to as financial leverage because it magnifies the gains and losses. Financial leverage is a measure of how much firm uses equity and debt to finance its assets.

As debt increases, financial leverage increases. It has been seen in different studies that financial leverage has the relationship with financial performance. This can result in volatile earnings as a result of the additional interest expense.

However, if a company is financially over-leveraged a decrease in return on equity could occur. It multiplies the value of every dollar of their own money they invest.

Leverage is a great way for companies to acquire or buy out other companies or buy back equity. Financial leverage is the use of borrowed money debt to finance the purchase of assets. In most cases, the provider of the debt will put a limit on how much risk it is ready to take and indicate a limit on the extent of the leverage it will allow. Increased Revenue The most logical step a company can take to reduce its debt-to-capital ratio is that of increasing sales revenues and hopefully profits.

This can be achieved by raising prices, increasing sales, or reducing costs. The extra cash generated can then be used to pay off existing debt.