Explain this statement: “Using leverage has both good and bad effects.”

Here is a tip:

Financial leverage is the use of borrowed capital.

Explanation

Firms can benefit from the use of debt if it can cover the fixed costs that come with its use. Since the cost of debt is fixed, if the firm can generate more operating profit then it borrows, additional net earnings will result. The firm will not need to pay additional costs because the cost associated with debt is fixed. But if the firm is not able to generate enough operating profit to service the cost of debt, the firm will incur a loss because regardless of the income of the firm, the same amount of cost should be paid.

Verified Answer

Financial leverage can benefit the firm if borrowing money can enable it to sell more goods or provide more services. But financial leverage can also harm the firm if it cannot generate enough income to cover the fixed cost.