Leverage

Leverage is the concept of raising money by borrowing or by issuing preferred stock.  If the borrowed capital can be invested and earn a return that is greater than the cost of borrowing the money, then net income and the return on common equity will increase.

Leverage can also have an undesirable effect on common stock.  If the return on total assets should fall below the average cost of borrowed capital, then leverage will decrease net income and the return on common stockholders equity.

Extensive use of leverage can pose a significant risk to common stockholders.  For example, if a business were to borrow so much money that they become unable to meet the interest and principal payments, then creditors may force a liquidation or reorganization of the company.