Leverage is a term widely used in the financial world that refers to a financial instrument or strategy. A form of leverage is borrowed capital for a business venture, and is limited by the amount of equity funding available for a project.
According to Ezra Solomon “Leverage is the ratio of net returns on shareholders equity and the net rate of return on capitalisation”
According to J. C. Van Home “Leverage is the employment of an asset or funds for which the firm pays a fixed cost of fixed return.”
There are three types of Leverage: Operating Leverage, Financial Leverage and Combined Leverage.
Operating leverage is the use of fixed operating costs to provide a larger return on investment. Companies can increase the percentage return they see on their invested capital by using operating leverage. If the market value of an asset is higher than its book value, then you have an operating leverage. This allows you to use your fixed costs (depreciation, insurance, etc) and invest in your business instead.
Degree of Operating Leverage
The earnings before interest and taxes change with an increase or decrease in the sales volume. Operating leverage is used to measure the effect of variation in sales volume on the level of earnings before interest and taxes (i.e. EBIT).
Operating leverage is the difference between how profitable an investment is on a risk-adjusted basis and what an investor would realize if they sold their holdings in the investment. Operating leverage is the most important factor when deciding which investments to buy, sell or hold.
Operating leverage is important for business owners because it means that the expenses a company pays decreases as profits increase. This can lead to larger profits, which in turn increases the value of a company and increases the owner’s wealth.
The operating leverage at any volume of sales is defined as its degree. The degree of operating degree is computed by dividing contribution by EBIT.
Here, Contribution = Sales – Variable Cost
EBIT = Sales – Variable cost – Fixed Cost
Financial leverage refers to the practice of borrowing money in order to increase your business’s net worth. Financial leverage increases the potential for profit and collateral for risky investments. It is primarily concerned with the financial activities which involve raising of funds from sources for which a firm has to bear fixed charges such as interest expenses, loan fees etc. These sources include long-term debt (i.e., debentures, bonds etc.) and preference share capital.
Degree of Financial Leverage
Financing leverage is a measure of changes in operating profit or EBIT on the levels of earning per share.
Financial leverage = Percentage change in EPS / Percentage change in EBIT = Increase in EPS / EPS / Increase in EBIT/EBIT
The financial leverage at any level of EBIT is called its degree. It is computed as ratio of EBIT to the profit before tax (EBT).
Degree of Financial leverage (DFL) = EBIT / EBT
The value of degree of financial leverage must be greater than 1. If the value of degree of financial leverage is 1, then there will be no financial leverage.
The combined leverage concept is developed by the effective use of existing assets in order to achieve the required results. The most common way used to do this is by the combination of a financial lever and an operational leverage. When there is no available resource, financial leverage can be used as an “open-ended” solution.
The combined leverage can be measured with the help of the following formula:
Combined Leverage = Operating leverage × Financial leverage
If a firm has both the leverages at a high level, it is risky. Therefore, if a firm has a high degree of operating leverage the financial leverage should be kept low as proper balancing between the two leverages is essential in order to keep the risk profile within a reasonable limit and maximum return to shareholders.