Why is financial leverage important?


Quick Answer

Financial leverage is important because it allows a company to maximize the profits earned by shareholders as compared to profits earned from equity operations. Companies that demonstrate the ability to manage leverage by repaying debts on time increase their chances of getting loans at better interest rates.

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Full Answer

Financial leverage allows a company to borrow huge loans to invest in infrastructure, which can boost capacity and cause the company to benefit from increased economies of scale. A company can use borrowed funds to make long-term investments, such as building a factory in order to free up cash for more immediate uses, such as paying suppliers and workers.

Most companies use financial leverage to increase the return on investment of the capital employed within a business. Financial leverage should be treated as a calculated risk that is implemented under the right conditions to generate maximum returns. Excessive use of financial leverage puts a company at great risk of going bankrupt as a result of high interest payments. Investment banks use leverage to borrow loans with extremely low interest and invest in bonds with higher yields, which can generate significant profit.

The acid-test ratio is used to determine the short-term ability of a company to repay its current liabilities. The financial leverage of a company is measured using the total-debt-to-capitalization ratio.

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