financial leverage

  

Definition

The use of borrowed money to increase production volume, and thus sales and earnings. It is measured as the ratio of total debt to total assets. The greater the amount of debt, the greater the financial leverage.

Since interest is a fixed cost (which can be written off against revenue) a loan allows an organization to generate more earnings without a corresponding increase in the equity capital requiring increased dividend payments (which cannot be written off against the earnings). However, while high leverage may be beneficial in boom periods, it may cause serious cash flow problems in recessionary periods because there might not be enough sales revenue to cover the interest payments. Called gearing in UK. See also investment leverage and operating leverage.


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