Today when companies have structured long-term debt, it is important to leverage the borrowed money to make it work for you in what the accounting world calls financial leverage. Basically financial leverage allows a firm to extend their reach, enter new markets, increase market share, etc. by borrowing money from others who are willing to loan the money on the principle that the loan will be paid back with interest and within a certain timeframe agreed upon by both parties. This allows the firm to declare the interest paid on the loan as a deduction on taxes. Furthermore, if the money borrowed can be invested to return more money back to pay for the interest of the loan then you will have an increase in owners" equity. .
To see how financial leverage works we will compare a firm who has borrowed money to invest in the company and a firm where no borrowing took place. For the background piece, assume that each company wants to buy a piece of equipment costing $ 200,000 and would generate profits of $ 80,000 if purchased. The owners" of the first firm contribute the full .
$ 200,000 of their own money in the purchase of equipment. The return on investment would be return divided by equity resulting in forty percent for the firm. The second firm decides to borrow $ 100,000 and contribute the other $ 100,000 in the purchase of the equipment. The interest rate is fixed at ten percent. Using the same formula of return divide by equity, we still receive the same forty percent as the first firm but the difference lies with the amount of equity between both firms. The second firm only has $ 100,000 equity in the equipment purchased because of borrowed funds. The expense of the loan cost $ 10,000. The expense will cause the original profit of $ 80,000 to shrink to $ 70,000. Here the return using return divide by equity would result in fifty-six percent. The difference lies in one firm took advantage of borrowed money still earning the same on investment as the first firm but only contributed half as much money.
