Leverage definition
/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.
