A financial leverage that negatively impacts return on equity (ROE). A firm with any amount of debt is said to be using leverage (i.e., it is a levered firm). The more debt it has, the more leverage it uses. However, it is particularly important for a firm using leverage to determine the optimal capital structure or how great a proportion of its funding should be secured from debt and how much from owners. Empirical evidence shows that levered firms have better returns in good times that do unlevered firms, but have worse returns in bad times. This has to do with the amount of debt: the greater the debt, the greater the risk.

Increased risk results in higher interest rates on additional debt. When rates are high relative to return on assets (ROA), financial leverage may result in lower financial performance reflected in decreased ROE (leverage wipes out earnings due to high interest rates). Likewise, ROE may be adversely affected when a firm with debt faces unfavorable conditions that make its earnings less than expected (leverage devours meager earnings).