finance
Leverage (Financial)
Using debt to amplify returns - and amplify risk.
Definition
Financial leverage is the use of debt to fund the business. Used well, leverage amplifies returns: $200K of equity plus $300K of debt deploys $500K of capital, and the returns on the full $500K accrue to the equity. Used badly, leverage amplifies losses and creates fragility - interest payments don't pause during downturns. The debt-to-equity ratio measures leverage; service businesses typically stay under 1:1 (debt no more than equity), capital-intensive businesses can run higher. The question is never 'should I use debt' but 'at what level does debt put the business at risk'.
In your business
- →Cap debt at the level you could still service with revenue down 30%
- →Use debt for growth investments with predictable returns, not for covering shortfalls
- →Watch interest coverage ratio (EBIT / interest expense) - under 3x is fragile