Definition of Leverage
In accounting and finance, leverage is the use of a significant amount of debt to purchase an asset, operate a company, acquire another company, etc.
Since the cost of debt is normally less than the cost of obtaining additional stockholders' equity, it is wise for a company to use some debt to control a larger amount of profitable assets. However, too much debt can mean significant risk when business conditions decline.
Leverage is also known as trading on equity.
Examples of Leverage
A company's leverage can be measured by the following financial ratios:
In these ratios, debt includes the company's current and noncurrent liabilities such as:
- Bonds payable
- Bank loans
- Other loans
- Accounts payable
- Other amounts owed
In a related Q&A we illustrate how leverage can increase or decrease the returns on investments.