Levers are necessary in physics to enable the lifting of a nearly impossible weight. With their application, they permit the use of less force than would normally be required without them. There are two forms of leverage applied to companies to bring in an increase of profits to its owners: operating leverage and financial leverage.
Operating leverage balances the mix of fixed and variable costs in its operations. Financial leverage is the degree to which a company utilizes borrowed money. All companies employs some degree of financial leverage. The manipulation of costs and investments allows companies to maximize their profit.
Investors may choose to use financial leverage to increase the return on their investment in a company. Instead of investing all the assets a company requires, they may choose to invest some of their own capital while borrowing the remainder needed. Borrowed money does introduce an annual interest charge. Despite the cost of interest, the return on owner’s equity can increase.
However, when interest rates are high or the return on assets is low, financial leverage may be a poor investment tool. When a company enters into debt, it puts the company at risk. It may find itself paying higher interest rates on borrowed funds than predicted.
Financial leverage can maximize the advantages of growth but any damage that occurs if business slows is also maximized. An investor should examine a company’s debt structure and profit patterns to adequately analyze its use of financial leverage. A company will list their costs by function and not by behavior.