Financial leverage
In one sentenceUsing borrowed money at a fixed cost to finance assets, so the owners' return rises if the assets earn more than the interest and falls if they earn less.
Simply put
A loan raises the return on the owners' money as long as the return on assets is higher than the loan interest: the difference goes to the owners. This is what "leverage" means.
But it raises losses in the same way: the interest is fixed even in a bad year. That is why it is read with the debt ratio and interest coverage.
Worked example
A business with assets of 1,000,000 SAR makes a profit before interest of 100,000 SAR (10%). It financed half with a 500,000 SAR loan at 6% interest and half from the owners (ignoring Zakat for illustration).
Return to owners without a loan = 100,000 ÷ 1,000,00010%
Interest = 500,000 × 6%30,000 SAR
Owners' profit with the loan = 100,000 − 30,00070,000 SAR
Return to owners with the loan = 70,000 ÷ 500,00014%
Formula: Return on equity = (profit before interest − interest) ÷ equity
Don't confuse it with
Operating leverageOperating leverage comes from fixed operating costs such as rent, and financial leverage from fixed interest on loans.