Financial leverage is one of the two forms of leverage used in business. Financial leverage utilizes debt to expand operations and increase revenues. The idea is that with the increase in revenues the margins generated will cover the associated debt service thus increasing profits for the business without increasing risk to the owners.
Leverage refers to the ability to lift a heavier load using a fulcrum and a lever. The common image is a board on a triangular pivot point with a heavy weight (M1) on one end and a lighter weight (M2) on the other. As the lever shifts towards the lighter load it starts to lift the heavier weight. In effect, as the distance ‘b’ gets longer, it becomes easier to lift M1. This principle works with finances too. How so?
Of the basic business principles, economies of scale has the greatest impact on profitability over any other business principle. As an enterprise’s investment is spread over higher volume the cost per unit of production decreases. The differential between sales price and cost changes add to the overall profitability for the company.
Economies of scale exists in two distinct forms. One isn’t reported in the financial statements and is referred to as the ‘learning curve’. The second form is identified in the financial reports and is called ‘leverage’. When both forms exist in a business and tweaked to perfection, efficiency is maximized and therefore profits reach optimum peaks. Once achieved, the business must exercise the same forms of scale as they grow from a start-up to a publicly traded company.
Financial leverage refers to using a third party’s money to increase profit for the borrower. With real estate, the profit or equity in the property is the weight being lifted by the use of a lever (borrowing money) on the fulcrum (the property).
In the simple lever and fulcrum machine the force is magnified onto a load. The machine creates a mechanical advantage, a form of force amplification. In business the principle is exactly the same. Except here we are not moving a physical object but the objective is to amplify the profitability or financial gain by using some form of a lever and applying this lever to a fulcrum and generating financial advantage.
