In this article we’re discussing financial leverage, meaning, purpose, use cases, and much more.
This article is part of our series on banking basics, ranging from opening different types of bank accounts around the world to understanding how various aspects of the banking system operate.
Feel free to use the table of contents to jump ahead to the sections most relevant to you.
Table of Contents
- Financial Leverage Meaning
- Personal Financial Leverage Ratios
- Frequently Asked Questions
- Do You Want Help Opening Bank Accounts?
Financial Leverage Meaning
Financial leverage refers to the use of borrowed funds to finance investments. The three primary types of financial leverage are operating leverage, financial leverage, and combined leverage.
The advantages of financial leverage include an increased return on investment, the ability to acquire assets, increased profitability, and (in certain instances) tax benefits. In short, the importance of financial leverage boils down to being able to acquire assets you wouldn’t otherwise have the funds to acquire in the most capital efficient way possible.
On the other hand, the disadvantages of financial leverage include increased financial risk, costs of servicing debts, impact on cash flows, negative outcomes from market volatility and rising interest, and more. Needless to say, the impact of financial leverage on risk compounds as market conditions turn negative.
Considering both the advantages and disadvantages of financial leverage, it’s clear that managing financial leverage and financial leverage ratios responsibly is critical to a successful outcome. Unfortunately, while the role of financial leverage in investments is well known, following the best practices for using financial leverage is less common.
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Personal Financial Leverage Ratios
The main differences between personal leverage and leverage in business is the purpose of the financial leverage, the sources of financing, and the scope at which personal leverage is undertaken compared to business leverage.
That said, the measurement of personal and business financial leverage also differs. When it comes to personal financial leverage, the key ratios include the debt-to-income ratio and the debt-to-asset ratio.
On the other hand, the most common financial ratios in business include the debt-to-equity ratio, the debt-ratio, the equity-ratio, and the interest coverage ratio.
Frequently Asked Questions
Below are a few of the most common questions we receive from people looking into the meaning of financial leverage. If you have further questions you would like to ask our team, don’t hesitate to get in touch.
Why Is Financial Leverage Important?
Financial leverage is important because it allows businesses to enhance profitability, expand operations, and acquire strategic assets that they would not otherwise be able to acquire.
Is Financial Leverage Good or Bad?
Financial leverage is good when it is used responsibly. Unfortunately, both individuals and businesses tend to increase their exposure to leverage beyond the levels that they can personally sustain. As a result, they constrain their resources and end up trapped. On the other hand, using financial leverage for productive purposes can result in significant financial efficiency gains for businesses and individuals.
What Is the Meaning of Leverage in Finance?
Leverage in finance refers to the use of borrowed funds in order to finance investments, diversify sources of capital, increase profitability, expand operations, and acquire assets.
What Are the Most Common Financial Leverage Ratios?
The most common financial leverage ratios are the debt-to-equity ratio, the debt-ratio, the equity ratio, and the interest coverage ratio.
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