Financial Leverage means using borrowed money to increase your return on investment. Financial leverage explains how taking debt risks can actually be beneficial: Borrowing money to make money could be a good thing. For instance if you can borrow money at 3% but invest it at 12%, you are 9% better off than you were. The problem comes in when people borrow money that gives a diminishing return.

To understand financial leverage, we will need to understand the following terms:

Debt to Asset ratio

Borrowing money is risky business because it exposes you to more risks in times of economic distress. With that said, debt is not always a bad thing if used wisely. The level of debt risk is measured by the debt to asset ratio as follows:

Total debt/ Total assets

Return on equity ratio

Return on equity ratio is the relationship between net income and equity computed as follows:

Net Income/ Equity

Financial Leverage

To understand financial leverage, I will compare the financial ratios of 2 businesses ABX Corp and ABC Corp.

ABX Corp invests $8,000 but gets a return of 12.5% while ABC Corp invests $2,000 and gets a return of 20%. Using debt to increase your return on equity is called financial leverage. Also, notice the adverse effect of debt on the income statement, ABX Corp had net income of $1,000 because they had to pay more interest expense due to the larger debt. The general argument (not my argument) is ABC Corp used borrowed money and earned a higher return on investment, so it does not really matter that net income is lower.

Debt must be used with caution: Even though your return on equity could be higher, you could go under water if there is not enough cash to pay your debt obligations in a downturn economy. Unlike equity investments, debt obligations have to be paid in both up times and down times.