Financial Leverage refers to the use of borrowed funds (debt) by a company to finance its assets, investments, or operations with the goal of increasing shareholder returns. It magnifies both potential gains and potential losses, depending on how effectively the borrowed capital is utilized. In simple terms, leverage allows a business to control more resources than it could with only its own equity.

The formula for Financial Leverage is often expressed as:

Financial Leverage = Total Debt / Shareholdersí Equity

A higher leverage ratio indicates that the company relies more on debt financing, while a lower ratio suggests more conservative financing through equity. Leverage can enhance earnings per share (EPS) when the return on investment exceeds the cost of debt. However, if returns fall short, it can lead to financial strain, higher interest obligations, and increased default risk.

For example, if a company invests ?10 croreó?6 crore from debt and ?4 crore from equityóand earns ?2 crore in profit, the returns for equity holders would be amplified due to leverage. But if the business underperforms, the same debt magnifies losses, as interest payments must still be made regardless of profits.

From an investorís perspective, Financial Leverage provides insight into a companyís risk profile and capital structure. Highly leveraged companies are more sensitive to changes in interest rates and economic conditions, while firms with lower leverage maintain greater financial flexibility.

In summary, Financial Leverage can be a powerful tool for growth when used prudently. It helps companies expand operations and enhance returns, but excessive leverage can expose them to significant financial and operational risks. Therefore, striking the right balance between debt and equity is essential for long-term financial stability.