The use of debt is sometimes described as financial leverage because debt can have the effect of increasing the return on equity.

Question

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When a company uses debt to finance its operations or investments, it can increase its return on equity if the return on the investment or assets it purchased via debt is higher than the cost of debt. This is because the cost of debt is usually lower than the cost of equity, so by adding debt to the financing mix, the company can lower its overall cost of capital, which can then increase its return on equity. However, it is important to note that using debt also increases the risk of financial distress and bankruptcy, which could outweigh the benefits of financial leverage in certain situations.

The Use of Debt Is Sometimes Described as Financial Leverage