What Is Financial Leverage?

What Is Financial Leverage?

Let me explain financial leverage directly: it's the practice of borrowing money, investing those funds, and aiming for returns that exceed the costs of servicing that debt. As a company, you can use this debt to generate more revenue, but remember, it comes with risks. I see leverage often applied when businesses invest in expansions, acquisitions, or other growth strategies. It's also an investment approach where you use financial instruments or borrowed capital to boost potential returns on your investments.

How Financial Leverage Works

Leverage works by using debt or borrowed capital to pursue an investment or project, often to strengthen an entity's equity base. Both investors and companies rely on this concept. As an investor, you can use leverage to greatly increase returns through instruments like options, futures, and margin accounts. For companies, it means financing assets with debt to drive business operations and growth, rather than issuing stock.

If you're not comfortable with direct leverage, you can access it indirectly by investing in companies that use it routinely to finance or expand operations, without upping your own outlay. The core idea of financial leverage is to multiply potential returns from a project, but it also multiplies downside risks if things don't work out. When I hear something described as 'highly leveraged,' it means it has more debt than equity.

How to Calculate Financial Leverage

You calculate financial leverage using a set of ratios that show how much debt a company uses to maximize profits. Start with the debt ratio, which is total debt divided by total assets; this tells you how much debt funds the assets. A high ratio means heavy reliance on leverage—if it's 1.0, there's $1 of debt per $1 of assets; above 1.0, more debt than assets; below, more assets than debt. Include all short- and long-term debt in this.

Next, the debt-to-equity (D/E) ratio compares total debt to total equity, focusing on financing sources. A D/E over 1.0 indicates more debt than equity, but that's not always bad—it depends on the industry. For example, startups might have higher ratios due to limited financing options.

The debt-to-EBITDA ratio divides debt by earnings before interest, taxes, depreciation, and amortization, showing income available to pay debt. Higher ratios mean more leverage relative to earnings, but note that EBITDA isn't always a true earnings picture as it's non-GAAP and excludes key expenses.

The equity multiplier is total assets divided by total equity, revealing how assets are financed. A low multiplier means more equity financing and less leverage. In DuPont analysis, you use this to help calculate return on equity by multiplying it with asset turnover and profit margin.

The degree of financial leverage (DFL) is the percentage change in EPS divided by the percentage change in EBIT, showing EPS sensitivity to operating income changes—a high DFL means volatile earnings.

For consumers, the leverage ratio is total household debt divided by disposable income; high values indicate heavy debt loads, which can make loans harder to get.

Advantages and Disadvantages of Financial Leverage

Financial leverage has clear upsides and downsides you need to consider. On the advantage side, it lets investors and traders amplify profits by multiplying initial investments with borrowed capital, giving access to pricier options you couldn't afford otherwise. It's especially useful in short-term, low-risk scenarios needing high capital, like company acquisitions or buyouts that lead to mid-to-long-term growth. Smart companies use it to seize opportunities and exit positions quickly without tying up extra capital in risky bets.

But disadvantages are significant: leverage amplifies losses just as it does gains, potentially leading to losses exceeding your initial investment. You'll face fees, premiums, and margin rates from brokers, and you must maintain margin accounts—losing trades still leave you liable for extras. It's complex too; you have to monitor positions closely and may need to add capital if your account falls short of requirements.

Financial Leverage vs. Margin

Margin is a form of leverage where you use cash or securities as collateral to boost buying power in markets. It lets you borrow from a broker at a fixed rate to buy securities, options, or futures, expecting high returns. Essentially, margin creates leverage by increasing your purchasing ability based on your account balance—for instance, $1,000 collateral for $10,000 in securities gives 10x leverage.

Example of Financial Leverage

Take a company starting with $5 million from investors as equity to operate. If it borrows $20 million more, it has $25 million for operations, creating more shareholder value opportunities, but with a high debt-to-equity ratio that could be normal or risky depending on the industry. Real-world cases like Apple's $4.7 billion in Green Bonds from 2016 to 2023 show how debt can fund expansions like low-carbon manufacturing, succeeding when revenue outpaces bond debt costs.

The Bottom Line

You can boost equity bases through methods like financial leverage, where businesses borrow to fuel growth and investors access instruments with less upfront money. But it's risky, so weigh the pros and cons against your own financial situation and goals before diving in.