Financial leverage which is also known as leverage or trading on equity refers to the use of debt to acquire additional assets.
Financial leverage deals with the profit magnification in general. It is also well known as gearing or ‘trading on equity’. The concept of financial leverage is not just relevant to businesses but is equally true for individuals.
Debt is an integral part of the financial planning of anybody whether it is an individual, firm, or company. We will try to understand it from the business point of view.
The financial leverage formula is measured as the ratio of total debt to total assets. As the proportion of debt to assets increases, so too does the amount of financial leverage.
Financial leverage is favorable when the uses to which debt can be put generate returns greater than the interest expense associated with the debt. Many companies use financial leverage rather than acquiring more equity capital, which could reduce the earnings per share of existing shareholders.