Leverage

Leverage is a key concept in finance and business strategy, describing how organizations can magnify both potential returns and risks. Financially, leverage often refers to using borrowed funds, debt to increase returns on equity for shareholders. More broadly, it includes any mechanism such as fixed costs, contracts or strategic choices that amplifies outcomes from small changes. In the UK, gearing is often used interchangeably with leverage. Leverage applies at multiple levels from corporate finance to operations. Financial leverage traditionally refers to the use of borrowed capital to finance the acquisition of assets. When a company finances itself with debt rather than using its own capital, it does so in hope that the returns on those assets will exceed the cost of borrowing. This can substantially increase the return on equity if things go well. Example, if the cost of debt is lower than the return generated by the firm's assets, shareholders benefit from leveraging up their gains. However, financial leverage is a double edged sword. Increased debt also means increased risk. Any adverse movement in profit or income can be exacerbated, potentially threatening the firm's solvency. Leverage is not limited to financing choices. Operating leverage examines how a business's cost structure magnifies the impact of changes in sales on operating income. A firm with high fixed costs and relatively low variable costs,