Leverage

Definition

The financial term leverage refers to the use of debt to increase the total profits returned to the company's equity holders.

Explanation

When companies borrow money from creditors, they can use those funds to make investments in projects that will return additional profits to the owners of the company (common shareholders).  As long as these new projects provide an adequate return on investment, shareholder wealth will increase.

Extensive or overuse of leverage can pose a serious risk to these same common stockholders.  If these projects did not provide an adequate return on investment, the company may not be able to meet the interest and principal payments on their loans. Creditors may force the company into bankruptcy, which could result in liquidation, or reorganization.

Leverage ratios are financial measures used to quantify the relative amount of debt used by companies.

Related Terms

return on investment, leverage ratios, bankruptcy