A technique that involves the use of borrowed funds (debt) wholly (100% debt) or partially (a mix of debt and owners’ equity) alike. Firms use financial leverage to widen their capital base and thus enhance their return on equity (ROE). The right amount of leverage (percentage of debt to equity) can bring about a positive impact on return on equity. In essence, it increases a company’s risk and, as a result, its cot of additional capital. Logically, the earnings generation power of a company must be large enough to allow it service its debt and still retains an amount of earnings that would be added up to return on unleveraged equity. The effect of financial leverage (FL) can be calculated using the following equation:
Effect of FL = ROE after leverage – ROE before leverage
Where:
ROE= ROA x FL
Where ROA denotes return on assets.
For an example of how financial leverage may increase return on equity, see: financial leverage- an example.
