Financial Leverage Definition and Example
Financial Leverage Definition – “The extent to which a company’s assets are financed by debt. A company that has a high debt-to-equity ratio (by industry standards) is said to be highly leveraged”.
In simple words, it refers to the degree the debt or borrowings are used to finance the company’s assets. Usually, companies use either debt or equity to buy or finance the assets. The more the business uses debt to finance their assets, the higher the financial leverage.
Both equity and debt has their own benefits. In case company finance its assets with debt, then the owner’s equity does not dilute. Most of the businesses goes for debt financing but to a certain point only. As excessive debt financing could leads to increasing the default risk.
In Balance Sheet you find Financial Leverage on the right hand side. The main reason behind using financial leverage is to improve the return on equity and to increase the earnings per share. High financial leverage leads to either default or bankruptcy. There are various ratios to assess the financial leverage of a company. For example – debt/equity ratio.
Financial Leverage Example
Let’s discuss an example to understand the Financial Leverage definition more clearly.
Case 1 – Ram buys a plot for Rs. 5,00,000. And he spent his money for doing the same. There is no financial leverage.
Case 2 – Shyam buys a plots of Rs. 10,00,000. However, he invest his own money to the extent of Rs. 5,00,000 and borrows 5,00,000.
Assume the price of the plot increases by 20% and then these plots are sold by their owners. So Ram has Rs. 1,00,000 gain. On the other hand, Shyam’s plot will sell in Rs. 12,00,000. He made investment of Rs 5,00,000 and earns gain of Rs. 2,00,000 on it. This is the power of financial leverage.
Related Financial Terms of Financial Leverage
- Net Income Definition | Formula | Example | Importance
- Debt Definition – Meaning and Example
- Capital Gains Tax
Importance of Financial Leverage – Why Financial Leverage is Used?
Financial Leverage plays an important role in not only making maximum return on investment but also maximizes the shareholders wealth. In addition this, it increases the business capacity to invest in a project. By borrowing from outside, business can invest in project even if they don’t have sufficient cash in hand. It is kind of calculated risk that business takes in order to maximize their returns.
Those companies which returns the borrowing fund of time, even get loans at cheaper rates or very easily. On the other hand, a higher financial leverage is also not good for the business, as it can lead to insolvency or bankruptcy. So it is very important to give a deep thought in order to decide what is the right debt to equity ratio.