Financial Leverage

When a company borrows at a fixed interest cost and invests the money in assets that earn more than that cost, the extra return goes to shareholders. This boosts return on equity. But if the assets earn less than the cost of borrowing, shareholders bear the shortfall.

For example, a company has assets of 1,000 that earn operating profit of 100, a 10% return. If it is funded entirely by equity, ignoring tax, shareholders earn 10%. If instead it is funded by 500 of equity and 500 of debt at 6%, it pays 30 of interest and earns 70 for shareholders on their 500, a return of 14%. If operating profit fell to 20, the all-equity company would still earn 4%, but the leveraged company would lose 10 after interest.

Financial leverage is measured by ratios such as debt-to-equity, the equity multiplier and net debt to EBITDA.

It differs from operating leverage, which comes from fixed operating costs. Together, the two determine how volatile a company's profits are. A company with both high operating leverage and high financial leverage is especially vulnerable to falling sales.