- The relative proportion of debt and equity used to finance a company is known as the debt/equity ratio, or sometimes simply the equity ratio. This is an important ratio for many investors who consider it an indicator of the overall financial health of the company.
- Financial leverage is a term used to describe a feature of the debt/equity ratio of a company. When a company takes on debt obligations, it must pay a predetermined interest rate in return for the right to use that money to invest funds in its operations. While the interest rate is fixed, the earnings of the company, or its return on investment, can be larger or smaller than the interest rate. In this sense, the earnings or losses of the company are leveraged by the amount of debt financing the company has. For example, if the company's interest rate is 10 percent and the company can achieve an 18 percent rate of return on the funds underlying that 10 percent interest rate, it can leverage those funds to achieve a net 8 percent rate of return.
- Among the dangers a company faces when using debt for financial capital is that the company may be unable to pay its interest rate obligations or these obligations may place a significant strain on its overall cash flow. This may not only reduce financial returns, but could ultimately put the company at risk of bankruptcy.
- A major consideration of financing a company through equity is that equity holders typically have ownership rights in the company. Additionally, common share holders, the predominant form of equity ownership, have voting rights in proportion to their ownership percentage of the company. This means that when equity is issued to fund the company, the company suddenly has new owners and new voters.
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