What is Financial Leverage and What Are the Advantages of Using It?
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What is Financial Leverage and What Are the Advantages of Using It?

When a company uses financial leverage, it provides certain advantages for equity holders in terms of increasing operating profit and lowering income taxes, which in turn raises returned earnings. The use of financial leverage is closely related to the issue of capital structure, the relative level of capital financed by debt vs. equity. Different financing affects the profit bottom line.

Financial leverage in business refers to the use of debt to finance a company’s various operating activities. Companies often obtain capital for business operations through both debt and equity. There are certain advantages of using financial leverage. The use of debt in addition to equity increases earnings for equity holders. For the same increase in operating profit, companies that use debt can also see a larger increase in earnings for their equity holders. Moreover, financial leverage helps companies lower taxes.

Financial Leverage. Companies may use financial leverage for capital expansion. Financial leverage usually benefits a company’s existing equity holders because companies can retain most of the increased operating profit generated by the additional use of debt, after paying interest on the debt to creditors. Since such profit retention belongs to company equity holders, for the same amount of equity investments, equity holders will have a higher return on their equity as a result of debt uses.

Expanded Earnings. Companies can also use financial leverage to meet the requirement of a targeted capital structure. While some companies may use an all-equity capital structure, others may use certain amount of debt in addition to equity. For the same amount of total capital and the same amount of operating profit that the total capital generates, a company with a capital structure of mixed debt and equity will provide expanded earnings for its equity holders on a per-equity-share basis, compared to a company with an all-equity structure and thus a larger number of equity shares.

Magnified Earnings. While the use of debt can lead to higher earnings for equity holders, it can further magnify earnings to a larger degree for equity holders of companies with debt than companies with no debt, given the same amount of increase in operating profits for both types of companies. Although the increased operating profits cause earnings increases for equity holders of both types of companies, the percentage of earnings increase is larger for equity holders of companies with financial leverage than companies without financial leverage, because of the smaller equity base in companies that use debt.

Lowered Taxes. Companies with the same amount of capital and operating profit but different capital structures will have different tax liabilities. Interest payments on debt from the use of financial leverage are tax-deductible expenses that can be subtracted from operating profit to arrive at a lower taxable income. On the other hand, companies that don’t use financial leverage enjoy no additional tax deductions. Thus, companies that use financial leverage incur lower taxes, given the same tax rate.

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