Leverage is the use of debt to finance an organization’s activities and asset purchases. When debt is the primary form of financing, a business is considered to be highly leveraged. Leverage is used to increase the return on equity for investors. For example, if investors buy $1 million of stock and the business then earns $100,000 of profits, their return on investment will be 10%. If they had instead invested $200,000 and the business had borrowed $800,000 to still achieve total financing of $1 million, the return on investment would now be 50% (though the after-tax cost of debt must also be considered).
Despite its obvious benefits, leverage is a problem when the cash flows of a business decline, since it then has difficulty making interest payments on the debt; this can lead to bankruptcy.