Many people think that for a business, borrowing money is a sign of weakness. To be sure, it can be a sign of financial weakness. But as we pointed out earlier in this chapter, businesses borrow money on a short-term basis for many valid reasons besides desperation. There are also valid reasons for long-term borrowing. In fact, successful businesses often use financial leverage created by borrowing money to improve their financial performance.
Financial leverage is the use of borrowed funds to increase the return on owner's equity.
The principle of financial leverage works as long as a firm's earnings are larger than the interest charged for the borrowed money. Of course, if the firm's earnings should drop below the interest cost of borrowed money, the return on owner's equity will decrease. To understand how financial leverage can increase a firm's return on owner's equity, study the financial information for Texas-based Cypress Springs Plastics presented in Table 19.3 . For a small business, long-term debt financing is generally limited to loans. Large corporations have the additional option of issuing corporate bonds.