What is Leverage?

Leverage is the use of debt to finance an organization’s activities and asset purchases. When debt is the primary form of financing, a business is considered to be highly leveraged. Leverage is used to increase the return on equity for investors. In essence, using debt instead of equity can boost the return that investors are experiencing.

Example of Leverage

As an example of leverage, if investors buy $1 million of stock and the business then earns $100,000 of profits, their return on investment will be 10%. If they had instead invested $200,000 and the business had borrowed $800,000 to still achieve total financing of $1 million, the return on investment would now be 50% (though the after-tax cost of debt must also be considered).

Disadvantages of Leverage

Leverage is a problem when the cash flows of a business decline, since it then has difficulty making interest payments on the debt; this can lead to bankruptcy when it has a large debt load. This issue can be mitigated by restricting the amount of debt that a business takes on, as well as by maintaining a reasonable cash reserve.