Financial leverage describes the use of borrowed capital to finance investments and thereby increase the potential return on equity. Companies therefore use leverage to make larger investments with additional borrowed funds than would be possible with equity alone.
The basic idea behind this is that investments can be scaled up more quickly using debt, provided that the return on the investment is higher than the cost of the debt.
The advantages of leverage are:
- greater investment capacity despite limited equity capital
- potentially higher return on equity
- faster scaling of business activities
- more efficient use of capital structures
At the same time, financial leverage also entails risks:
- fixed interest and repayment obligations
- increased financial burden amid weak business performance
- a higher risk of insolvency in the absence of revenue
- greater dependence on investors
A simple example:
If a company uses €1 million of equity and raises a further €1 million in debt, it can invest a total of €2 million. If this investment generates a high return, the share of profit attributable to equity increases disproportionately.
For start-ups, leverage plays an important role in their financing strategy, particularly when growth needs to be funded quickly. However, the use of debt capital is often limited in the early stages, as the risk to lenders is higher.
innoWerft helps start-up founders to understand capital structures, weigh up financing options and develop a balanced mix of equity and debt capital to support sustainable growth.