Financial leverage refers to the amount of borrowed money (debt) a company uses to finance its assets.
Debt is referred to as financial leverage because it acts as a fulcrum, magnifying the amount of gains or losses on an equity investment. For example, suppose that a real estate development company invests $10 million into a real estate project. The company finances the project using $2.5 million in equity and $7.5 million in bank financing. Suppose the company accrues $1.2 million in interest costs over the duration of the project. If the company is able to sell the real estate asset for $14 million, what is the company’s gain on its equity investment (ignoring transaction costs)? Out of the $14 million, the company must pay $7.5 million in loan principal and $1.2 million in interest, leaving $5.3 million. Out of the remaining $5.3 million, $2.5 million is a return of the company’s equity investment. Thus, the gain on equity is $2.8 million, or a percentage return of 112%. Had this project been 100% equity financed, the gain would have been $4 million on a $10 million equity investment for a percentage return of 40%. The financial leverage has magnified the gain.
Suppose in the above example that the company must sell the project for $8 million. If the project were 100% equity financed, the company would realize a $2 million loss on a $10 million equity investment for a 20% loss. However, the use of debt means that the company must pay the bank $8.7 million in principal and interest. The loss on the project is $3.2 million, or a percentage loss of 128% on equity. The financial leverage has magnified the loss.