Financial leverage is using debt to juice equity returns. If a company earns 15% on its assets and borrows at 8%, the extra 7% goes entirely to equity holders — boosting their returns. The more debt used, the higher the equity return (as long as the spread is positive). This is the fundamental appeal of leverage.
The debt-to-equity (D/E) ratio measures financial leverage. A D/E of 1.0 means equal debt and equity. Banks operate at extreme leverage — typical D/E of 8-12x (meaning $8-12 of debt for every $1 of equity). Real estate companies also use high leverage. Tech companies often have little debt. Higher leverage = higher potential returns but also higher risk.
The downside: leverage magnifies losses just as much as gains. If asset returns fall below the borrowing cost, equity gets crushed. A company earning 5% on assets while paying 8% on debt is losing 3% — and that loss is entirely borne by equity. This is why overleveraged companies fail first during downturns — Lehman (31:1), Bear Stearns (33:1) — and why regulators cap leverage ratios.