Financial leverage is the use of borrowed money, rather than owners' money, to pay for a business's assets. Because interest on debt is a fixed cost, any return on those assets above the interest rate goes to the shareholders, so leverage magnifies their return on equity in good years and their losses in bad ones. In accounting terms it is visible in the mix of liabilities and equity on the balance sheet. An older name for it is trading on equity.
How financial leverage relates to the main leverage entry
The general idea of leverage, including its uses in investing and trading, is explained in the main entry on leverage. In financial statement analysis, financial leverage is measured with ratios such as the debt-to-equity ratio, the debt ratio and the equity multiplier, which is total assets divided by total equity. For example, a company with $10 million of assets financed by $6 million of debt and $4 million of equity has an equity multiplier of 2.5. If its assets earn 8 percent after tax and its after-tax cost of debt is 4 percent, the extra return on the debt-funded assets lifts the return on equity well above 8 percent. The interest coverage ratio shows whether operating profit can comfortably carry the interest. Financial leverage is distinct from operating leverage, which comes from fixed operating costs, and from the regulatory leverage ratio used for banks.