Financial Leverage: How Companies Use Debt To Grow
Financial leverage means using debt to buy assets. This aims to increase shareholder profits if the asset returns are higher than the interest cost. It's risky because it magnifies losses if returns are low, potentially leading to financial problems. Companies should carefully consider taking debt to explore the opportunities in future.
Kishor kumar Bairagi24 Oct, 2025
Financial Leverage is considered a fundamental concept for any organisation. The company needs the funds for its growth and development. They can get through the debt way. High financial leverage could cause issues for the company. Creditors may start feeling that the company may be unable to pay back the debts, along with interest, on time. Companies are required to plan their financial debt. High and low financial leverage can have consequences for the growth and development of the organisation. Low financial leverage can increase the chance that a company may start losing growth opportunities.
What is Financial Leverage?
Financial leverage involves a company raising funds through debt rather than equity. When a company issues bonds, takes a bank loan, or uses any other form of borrowing, it is employing financial leverage. The funds acquired are then invested in assets, projects, or expansion activities. The business commits to paying a fixed interest rate on the borrowed capital, regardless of its profitability.
The key calculation for this strategy to be successful is simple: the Rate of Return on Assets (ROA) must be greater than the fixed Interest Rate on the debt. If, for instance, a company borrows money at a 5% interest rate and invests it in a project that yields a 12% return, the 7% difference (12% - 5%) goes directly to the equity holders. This positive effect is called "favourable leverage" or "positive leverage." Conversely, if the ROA is less than the interest rate, the company is experiencing "unfavourable leverage" or "negative leverage," which reduces shareholder returns.
Financial leverage is distinct from operating leverage. Operating leverage deals with a company’s fixed operating costs (like rent or salaries), while financial leverage deals exclusively with fixed financing costs (like interest expense). Both types contribute to a company’s overall business risk and profit volatility.
Importance of Financial Leverage in Business
Financial leverage holds importance for several reasons for the business. It helps the company to make great financial decisions, helping the growth and development of the organisation.
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Importance of Financial Leverage in Business |
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Magnification of Shareholder Returns |
Using more debt and less equity increases profit per dollar of equity invested. This raises Earnings Per Share (EPS) and can enhance the company’s market value. |
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Access to Greater Resources |
Leverage helps companies fund larger projects and growth opportunities that exceed their current equity base. |
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Tax Deductibility of Interest |
Interest on debt is tax-deductible, reducing taxable income and creating a “tax shield” that makes debt cheaper than equity. |
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Maintaining Ownership Control |
Taking on debt instead of issuing new shares prevents dilution of ownership, allowing existing shareholders to retain control. |
Types of Financial Leverage
While financial leverage is a singular concept, its measurement is seen through various financial ratios.
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Types of Financial Leverage |
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Measure |
Description |
Formula |
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Debt-to-Equity Ratio (D/E Ratio) |
Compares a company’s total liabilities to its total shareholder equity. A high ratio means the company relies more on debt financing. |
Debt-to-Equity Ratio = Total Debt / Total Shareholders’ Equity |
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Debt-to-Assets Ratio (D/A Ratio) |
Shows how much of a company’s assets are financed by debt. It gives insight into the firm’s overall financial structure. |
Debt-to-Assets Ratio = Total Debt / Total Assets |
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Degree of Financial Leverage (DFL) |
Measures how sensitive the company’s EPS is to changes in EBIT. A DFL of 2.0 means a 10% change in EBIT causes a 20% change in EPS. |
DFL = EBIT / (EBIT − Interest Expense) |
Calculating Financial Leverage
To illustrate the calculation and effect, consider Company A and Company B, both with total assets of $1,000,000 and operating income (EBIT) of $200,000. The tax rate is 30%.
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Metric |
Company A (No Leverage) |
Company B (High Leverage) |
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Total Assets |
$1,000,000 |
$1,000,000 |
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Total Debt |
$0 |
$500,000 |
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Total Equity |
$1,000,000 |
$500,000 |
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Interest Rate on Debt |
N/A |
5% |
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Debt-to-Equity Ratio |
0 |
1.0 ($500,000/$500,000) |
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EBIT |
$200,000 |
$200,000 |
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Less: Interest Expense |
$0 |
$25,000 ($500,000×5%) |
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Earnings Before Taxes (EBT) |
$200,000 |
$175,000 |
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Less: Taxes (30%) |
$60,000 |
$52,500 |
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Net Income |
$140,000 |
$122,500 |
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Return on Equity (ROE) |
14% ($140,000/$1,000,000) |
24.5% ($122,500/$500,000) |
Advantages of Using Leverage
The calculated example highlights the primary advantages of utilising Financial Leverage.
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Advantages of Using Leverage |
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Increased Return on Equity (ROE) |
Using debt successfully increases returns for shareholders, making leverage a key tool for boosting profitability. |
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Tax Efficiency |
Interest payments are tax-deductible, reducing the overall cost of borrowing and making debt cheaper than equity financing. |
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Capital Structure Flexibility |
Debt allows management to optimise the capital structure and lower the Weighted Average Cost of Capital (WACC), improving firm value. |
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Signal of Confidence |
A moderate level of debt shows the market that management is confident in the company’s ability to generate stable earnings. |
Disadvantages and Risks of Leverage
While the benefits are significant, the disadvantages and risks associated with Financial Leverage can be severe and must be carefully managed.
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Disadvantages and Risks of Leverage |
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Magnified Losses |
If profits fall, losses increase faster because interest must still be paid. Returns lower than interest cost reduce or turn negative the company’s earnings. |
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Increased Bankruptcy Risk |
High debt increases the chance of financial trouble. If the company cannot pay interest or principal, it may face bankruptcy. |
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Restrictive Covenants |
Lenders add rules that limit borrowing, dividend payments, or asset sales, reducing management’s freedom. |
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Higher Cost of Debt |
More debt makes lenders charge higher interest rates, increasing borrowing costs. |
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Loss of Credibility |
Too much debt makes a company look financially weak and reduces trust among investors and partners. |