What Is Leverage?

Financial decision is one of the integral and important parts of financial management in any kind of business concern. A sound financial decision must consider the board coverage of the financial mix (Capital Structure), total amount of capital (capitalization) and cost of capital (Ko).

Capital structure is one of the significant things for the management, since it influences the debt equity mix of the business concern, which affects the shareholder’s return and risk. Hence, deciding the debt-equity mix plays a major role in the part of the value of the company and market value of the shares. The debt equity mix of the company can be examined with the help of leverage.

Meaning of Leverage

The term leverage refers to an increased means of accomplishing some purpose. Leverage is used to lifting heavy objects, which may not be otherwise possible. In the financial point of view, leverage refers to furnish the ability to use fixed cost assets or funds to increase the return to its shareholders.

Definition of Leverage

James Horne has defined leverage as, “the employment of an asset or fund for which the firm pays a fixed cost or fixed return.

Types of Leverage

Leverage can be classified into three major headings according to the nature of the finance mix of the company.

Operating Leverage

The leverage associated with investment activities is called as operating leverage. It is caused due to fixed operating expenses in the company. Operating leverage may be defined as the company’s ability to use fixed operating costs to magnify the effects of changes in sales on its earnings before interest and taxes. Operating leverage consists of two important costs viz., fixed cost and variable cost. When the company is said to have a high degree of operating leverage if it employs a great amount of fixed cost and smaller amount of variable cost. Thus, the degree of operating leverage depends upon the amount of various cost structure. Operating leverage can be determined with the help of a break even analysis

Degree of Operating Leverage

The degree of operating leverage may be defined as percentage change in the profits resulting from a percentage change in the sales.

Uses of Operating Leverage

• Operating leverage is one of the techniques to measure the impact of changes in sales which lead for change in the profits of the company.
• If any change in the sales, it will lead to corresponding changes in profit.
• Operating leverage helps to identify the position of fixed cost and variable cost.
• Operating leverage measures the relationship between the sales and revenue of the company during a particular period.
• Operating leverage helps to understand the level of fixed cost which is invested in the operating expenses of business activities.
• Operating leverage describes the over all position of the fixed operating cost.

Finacial Leverage

Leverage activities with financing activities is called financial leverage. Financial leverage represents the relationship between the company’s earnings before interest and taxes (EBIT) or operating profit and the earning available to equity shareholders.

Financial leverage is defined as “the ability of a firm to use fixed financial charges to magnify the effects of changes in EBIT on the earnings per share”. It involves the use of funds obtained at a fixed cost in the hope of increasing the return to the shareholders. “The use of long-term fixed interest bearing debt and preference share capital along with share capital is called financial leverage or trading on equity”.

Financial leverage may be favourable or unfavourable depends upon the use of fixed cost funds.

Favourable financial leverage occurs when the company earns more on the assets purchased with the funds, then the fixed cost of their use. Hence, it is also called as positive financial leverage.

Unfavourable financial leverage occurs when the company does not earn as much as the funds cost. Hence, it is also called as negative financial leverage.

Degree of Financial Leverage

Degree of financial leverage may be defined as the percentage change in taxable profit as a result of percentage change in earning before interest and tax.

Alternative Definition of Financial Leverage

According to Gitmar, “financial leverage is the ability of a firm to use fixed financial changes to magnify the effects of change in EBIT and EPS”.

Uses of Financial Leverage

Financial leverage helps to examine the relationship between EBIT and EPS.

Financial leverage measures the percentage of change in taxable income to the percentage change in EBIT. Financial leverage locates the correct profitable financial decision regarding capital structure of the company.

Financial leverage is one of the important devices which is used to measure the fixed cost proportion with the total capital of the company. If the firm acquires fixed cost funds at a higher cost, then the earnings from those assets, the earning per share and return on equity capital will decrease.

Financial BEP

It is the level of EBIT which covers all fixed financing costs of the company. It is the level of EBIT at which EPS is zero.

Indifference Point

It is the point at which different sets of debt ratios (percentage of debt to total capital employed in the company) gives the same EPS.

Composite Leverage

When the company uses both financial and operating leverage to magnification of any change in sales into a larger relative changes in earning per share. Combined leverage is also called as composite leverage or total leverage. Combined leverage express the relationship between the revenue in the account of sales and the taxable income.

Degree of Combined Leverage

The percentage change in a firm’s earning per share (EPS) results from one percent change in sales. This is also equal to the firm’s degree of operating leverage (DOL) times its degree of financial leverage (DFL) at a particular level of sales.

Working Capital Leverage

One of the new models of leverage is working capital leverage which is used to locate the investment in working capital or current assets in the company. Working capital leverage measures the sensitivity of return in investment of charges in the level of current assets.