Short definition: Financial leverage is the use of borrowed capital (debt) to finance a company’s assets and operations.
Explanation: It is a strategy used to increase potential returns by using debt to amplify the effects of changes in a company’s operating income on its earnings per share (EPS). While financial leverage can magnify profits, it also amplifies losses and increases the risk of financial distress if a company is unable to meet its debt obligations.
Example: A company with high financial leverage might have a large amount of debt relative to its equity. This can increase its EPS if the company’s operating income is strong, but it can also lead to significant losses if the company’s operating income declines.
Additional information (optional): Financial leverage is measured by various ratios, such as the debt-to-equity ratio and the debt-to-capital ratio. Companies must carefully manage their financial leverage to balance the potential benefits of increased returns with the risks associated with higher debt levels.