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.
Many businesses finance their long-range activities with loans from commercial banks, insurance companies, pension funds, and other financial institutions. Manufacturers and suppliers of heavy equipment and machinery may also provide long-term financing by granting extended credit terms to their customers. When the loan repayment period is longer than one year, the borrower must sign a term-loan agreement. A term-loan agreement is a promissory note that requires a borrower to repay a loan in monthly, quarterly, semiannual, or annual installments. Long-term business loans are normally repaid in three to seven years.