Financial Leverage is the Art of Earning With Borrowed Funds.
Why Use Leverage?
Why do profitable firms borrow funds when they can continue operating without doing so? The answer has to do with the ways that companies invest in their own businesses. Borrowing results in leverage, which can increase the profitability of the firm’s investments.
- In a strong economy or when the business is otherwise doing well, owners may earn more on funds they borrow than they pay for the cost of borrowing. This in fact is the reason owners use leverage. When business is healthy, leverage increases earning power.
- The reverse can be true in a poor economy or if the firm performs poorly for other reasons. As a result, earnings may not even cover the interest due on loans. In this case, borrowing costs are therefore especially burdensome for owners. This is because leverage decreases earning power when business is poor.
Watch Leverage at Work
The leverage level for a business resides in the firm’s balance sheet. In particular, the balance sheet liabilities items and equities items, together, define two structures: the firm’s Financial Structure and its Capital Structure. Businesses achieve their desired level of leverage by setting and reaching certain objectives for their balance sheet equities and liabilities accounts.
See the feature article Capital and Financial Structures for a complete introduction to balance sheet structures and their role in defining leverage. The article shows how leverage impacts earnings gains and losses, in quantitative terms. Find free access to Capital and Financial Structures at:
Measure Leverage and Leverage Impact
Analysts focus on Five leverage metrics, each of which has its own way of showing how a firm’s owners and creditors share business risks and rewards:
- Total debt-to-assets-ratio (Debt ratio).
- Total debt-to-equities ratio.
- Long-term debt-to-equities-ratio.
- Equity-to-assets ratio.
Learn to understand and produce these metrics for any business from the income statement and balance sheet data. See the free online feature article Financial Leverage and Leverage Metrics (Gearing Ratios) at:
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By Marty Schmidt. Copyright © 2004-2020.
Solution Matrix Ltd, Publisher.