What Is Financial Leverage?
In business, financial leverage is the use of borrowed capital—usually in the form of corporate bonds or loans—to finance operations in order to generate income.
In order to grow in value, companies need to hire, expand, conduct research, develop new products and services, purchase equipment, and lease warehouses and offices. If a company does not have enough cash on hand to finance these activities, it must either issue additional equity (stock) or borrow money.
Companies “leverage” borrowed capital by using it to generate income and increase the value of the business. The more money a company borrows, the more “leveraged” it becomes. Ideally, the income generated from the use of borrowed capital should exceed the cost of borrowing it (i.e., interest payments). The more a company’s debt-generated income exceeds its cost of borrowing, the more effectively it is using leverage.
Why Do Businesses Use Leverage?
When a company issues common stock to raise money, it gives up a portion of its ownership to shareholders. When a company issues corporate bonds or takes out a loan, on the other hand, it is able to invest in new projects without relinquishing any ownership. When a company’s debt-financed investment pays off by increasing income, the company’s 222return on equity (ROE) increases because it didn’t issue additional equity in order to boost income.
How Do Businesses Use Leverage?
When companies sell corporate bonds or take out loans, they do so to fund specific income-generating projects. As mentioned above, common uses of debt financing include hiring, the purchase of assets like plants or equipment, research and development efforts, and even marketing. Additionally, debt financing may be used to acquire other businesses whose assets can be incorporated into the company’s income-generating strategy.
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Financial Leverage Example
An east coast-based beverage company whose beverages were sold in stores and restaurants across the country might use leverage in the form of a corporate loan to finance the purchase of a new beverage production and canning plant on the west coast in order to reduce the cost of transportation its inventory across the country.
By using a loan instead of issuing new shares, the company would not relinquish any additional ownership to stockholders. Ideally, the money saved on transportation would outweigh the cost of borrowing money to purchase the new plant in the long term, resulting in increased income for the company and a higher return on equity.