FINANCIAL LEVERAGE
Financial leverage is defined as the use of debt to acquire additional assets. Debt is employed to increase production which also leads to an increase in sales and revenue. A business is said to be highly leveraged when it employs more debt than equity in financing its business activities. A business level of leveraging is determined by the financial leverage ratio. This ratio normally indicates how heavily a business relies on debt to finance its activities. Financial leverage ratio is calculated by the formula;
Financial leverage ratio = total debt / shareholders equity.
Return on equity is a measure of the rate of return on the shareholders equity .It measures the firm’s efficiency in generating profits from every unit of the shareholders equity. In a firm, return on equity acts as an indicator of how well a firm uses its investment funds to generate earnings growth. A firm’s return on equity ratio is calculated using the formula;
Return on equity = net income /average shareholder’s equity.
A high ROE ratio also indicates high share price of the equity which helps the company to attract new funds since investors are more interested in companies with a strong ability to deliver on investments.
Financial leverage usually has a great impact on the firm’s return on equity. Kumar (2011) discussed various conditions in which the financial leverage affects return on equity.
In instances where a firm uses high level of leverage, it means that the firm has borrowed a lot of funds to finance its business activities. Financial over-leveraging means that a firm incurs a huge debt by borrowing funds at a lower rate of interest and utilizes the excess funds in high risk investments in order to maximize returns.
Financial leverage may also increase the firm’s return on equity if the earnings before interest and tax are more than the interest cost for the financial leverage. This therefore means that the firm is generating profits through the use of debt resulting to positive cash flows.
A firm which finances its activities by use of debt mostly has few shareholders. If a company with few shareholders makes profits from the debt employed, the debt is shared by few people. This helps increase the shareholders earnings per share which results to an increase in the return on equity.
However, employment of debt in a firm may be a risky activity. This is because debt contains a fixed interest regardless of whether a firm makes profits or not. Therefore in such instances, use of debt finances may result to losses.

REFERNCES
Kumar, V. (2011, March 7). Accounting Education. Retrieved October 4, 2011, from Accounting Education Web site: http://www.svtuition.org/2011/03/leverage-effect-on-roe.html