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Financial Leverage
There are many ways that one can finance a project. Either a company can use its investors own funds, that is equity, or borrowed money, meaning debt can be used. Generally, the two are used in a combination depending on the risk preference of the investor. Financial leverage is financial leverage "The degree to which an investor or business is utilizing borrowed money" (InvestorWords.com). There are many views on using debt to finance a company. Some would say that it is a bad thing, and that it feeds on itself, but then again, it could be used to boost up return on equity very easily. This is because it can be used to increase the asset base of the company, and hence increasing the earning power of the company, without actually increasing the amount of equity. The reason is that an equity investor is entitled to a share of the profits of the venture in proportion to his ratio of the total equity involved in the venture. A debt investor on the other hand...
Another advantage of debt financing is the tax advantage, as the interest payments are usually allowed as a tax expense.
The main difference is that the debt investor has a certain fixed amount of income, but his income is limited to that, regardless of what the outcome of the venture is, whereas the equity investor has no fixed return on his investment. Also, the debt is generally secured against the assets of the venture whereas equity is not. So in other words, the equity investor takes the debts investors share of the risk involved, but for a share of the debt investor's profit.
There are many risks involved with leverage. Having debt in the capital structure of a company creates a fixed operating cost for the company, which must be met at all times. If the company defaults on the fixed interest payments, then the debtor…
Reference:
InvestorWords.com, "Definition of Financial Leverage" http://www.investorwords.com/cgi-bin/getword.cgi?1952&financial%20leverage
The Motley Fool, www.fool.com
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