Financial Leverage
Explanation: Financial leverage refers to the use of borrowed funds to increase the potential return on investment. By using debt, companies and investors can increase the amount of capital available for investment, potentially amplifying returns. However, leverage also increases the risk of loss, as the debt must be repaid regardless of the investment’s performance.
Example: A company with $1 million in equity borrows an additional $2 million to invest in a new project. If the project generates a return higher than the interest on the borrowed funds, the company’s profits are amplified. Conversely, if the project fails, the company still owes $2 million plus interest, increasing its financial risk.
Reference Link: For more information on financial leverage, visit Investopedia’s Financial Leverage.
FAQs:
- What are the benefits of financial leverage?
- It can amplify returns on investment and allow for greater capital expenditure.
- What are the risks of financial leverage?
- It increases the potential for losses and financial distress if the investment does not perform as expected.
- How is financial leverage measured?
- Common measures include the debt-to-equity ratio and the leverage ratio.
- Can individuals use financial leverage?
- Yes, through mortgages, margin trading, and other forms of borrowing to invest.
- What is the difference between financial leverage and operational leverage?
- Financial leverage involves using debt to finance investments, while operational leverage refers to the extent to which a company uses fixed costs in its operations.