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Finance Textbooks Boundless Finance Capital Structure Thinking About

Financial Leverage

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Defining Financial Leverage

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Financial leverage, in a corporate finance sense, exists when a company

finances assets and internal operations through fixed obligations.

LEARNING OBJECTIVE[ edit ]

Identify ways a company can obtain leverage

KEY POINTS[ edit ]

Common ways to attain leverage include borrowing money, buying fixed

assets and using derivatives.

Fixed obligations create leverage because they allow a company to finance

operations using more capital than the company independently possesses.

Leverage is often expressed as a ratio and is specifically defined by the

amount of debt that a company uses relative to the company's assets.

Proper use of financial leverage can result in increased return on equity up to

a certain level of operating income. but it also exposes shareholders to higher
risk.

TERMS[ edit ]

financial leverage

any technique to multiply gains and losses, such as by borrowing

derivative

A financial instrument whose value depends on the valuation of an underlying

asset; such as a warrant, an option, etc.
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FULL TEXT[ edit ]

Defining Financial Leverage

In the field of finance, leverage is a general term for any technique that is
used to multiply gains and losses. Common ways to attain leverage are
borrowing money, buying fixed assets and using derivatives. While individual
investors can use the idea of leverage to to their advantage, we usually think
of leverage in terms of the capital structure of a larger corporate entity.

Financial Leverage in Corporate Finance

Sample Leverage Ratios

This graph shows leverage ratios for major investment banks.

For a company, finding the right capital structure involves finding the right
amount of financial leverage. Financial leverage is the financing of assets and
internal operations with fixed obligations. Examples of these types of
obligations include debt and preferred stock. This, in an accounting sense,
allows a company to acquire more goods without spending any additional
funds of its own.

Leverage is often expressed as a ratio and is specifically defined by the

amount of debt that a company uses relative to that company's assets.
Leverage is also expressed as the Degree of Financial Leverage, or DFL. DFL
is the percentage a company's earnings change as a result of a particular
change that a company makes in its operating income. The higher the DFL,
the riskier the business.

Proper use of debt and leverage can result in increased return on equity up to
a certain level of operating income, but mismanagement of this process can
have the opposite result of amplifying losses. Generally, the use of financial
leverage will improve financial performance, as long as returns are higher
than the costs of obtaining funds, or the cost of capital. In a perfect world,
management would favor more leverage whenever this holds true. However,
higher returns also result in higher risk for a business. As a company uses
more financial leverage, higher levels of operating income are needed to
cover the additional fixed obligations (interest on debt and fixed dividends on
preferred stock). Therefore, the use of financial leverage can become a
balancing act. It has the possibility of leading to higher returns for
shareholders, but it also has the possibility of producing higher risk for those
same individuals.

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PREV CONCEPT Benefits and Risks of Operating Leverage Impacts of

Financial Leverage NEXT CONCEPT

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Which of the following is a common way for a business to obtain leverage?

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Source: Boundless. Defining Financial Leverage. Boundless Finance.

Boundless, 26 May. 2016. Retrieved 27 Jul. 2016 from
https://www.boundless.com/finance/textbooks/boundless-finance-
textbook/capital-structure-13/thinking-about-financial-leverage-106/defining-
financial-leverage-451-3859/

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Source: Boundless. Defining Financial Leverage. Boundless Finance.

Boundless, 26 May. 2016. Retrieved 27 Jul. 2016 from
https://www.boundless.com/finance/textbooks/boundless-finance-
textbook/capital-structure-13/thinking-about-financial-leverage-106/defining-
financial-leverage-451-3859/