What is financial leverage?

Financial leverage simply means the presence of debt in the capital structure of a firm. In other words, we can also call it the existence of fixed-charge bearing capital which may include preference shares along with debentures, term loans etc. The objective of introducing leverage to the capital is to achieve maximization of wealth of the shareholders.

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 it is equally true for individuals. Debt is an integral part of the financial planning of anybody whether it is an individual, firm or a company. We will try to understand it from the business point of view.

In a business, a debt is acquired not only on the grounds of ‘need for capital’ but it is also taken to enlarge the profits accruing to the shareholders. Let me clarify it further. An introduction of debt in the capital structure will not have an impact on the sales, operating profits etc but it will increase the share of the equity shareholders, the ROE % (Return on Equity).