Leverage

Meaning
The term leverage is used to describe the companys ability to use the fixed cost assets or funds to magnify the returns to its owners.

Definition
According to James Home, leverage is the employment of an asset or sources of funds for which the firm has to pay a fixed cost or fixed return. According to J.E. Walter, Leverage may be defined as percentage return on equity to percentage return on capitalization.

Types of leverage
1. Operating leverage
It is associated with asset acquisition or investment activities. The operating leverage is the tendency of the operating profit to change disproportionately with sales. It may be defined as the ability to use fixed operating costs to magnify (increase) the effect of changes in sales on its operating profits (EBIT). A company is said to have a high degree of operating leverage if it employs a greater amount of fixed costs and a small amount of variable costs and vice versa. Operating leverage can be calculated with the help of the following formula: OL = C/EBIT Where, OL = Operating Leverage C = Contribution = Sales- variable cost EBIT = Earnings Before Interest and Tax

Degree of OL= %age EBIT/ %age sales

2. Financial leverage

Financial leverage is related to the financing activities of a firm and is also known as trading on equity. The financial leverage is the ratio of long-term debt to total funds employed. It may be defined as the tendency of the residual net income to change disproportionately with operating profit. It is defined as the ability of a firm to use fixed financial charges to magnify the effect of changes in EBIT on the earnings per share (EPS). Financial leverage is employed in hope to increase the return to common stock holder.

FL =EBIT/EBT Degree of FL= %age EBS/ %age EBIT

3. Combined leverage
Combined leverage is the product of operating leverage and financial leverage. Operating leverage affects the firms operating profit (EBIT) and financial leverage affects PAT or the EPS. The degree of operating and financial leverages is combined to see the effect of total leverage on EPS associated with a given change in sales. When financial leverage is combined with operating leverage the effect of change in revenues or earning per share is magnified. CL= C/EBT

Degree of CL = %age in EPS / %age in Sales

Uses or Significance of Leverage

Leverage refers to the use of fixed costs in an attempt to increase the profitability. Leverage affects the level and variability of the firm's after tax earnings and hence, the firm's overall risk and return. The study of leverage is significant due to the following reasons.

It helps in examining a relative change in the profits due to changes in sales. Leverage helps in determining the EPS of the company. Financial leverage indicates the market price of the shares.

Measurement Of Operating Risk Operating risk refers to the risk of the firm not being able to cover its fixed operating costs. Since operating leverage depends on fixed operating costs, larger fixed operating costs indicates higher degree of operating leverage and thus, higher operating risk of the firm. High operating leverage is good when sales are rising but bad when they are falling.

 Measurement Of Financial Risk Financial risk refers to the risk of the firm not being able to cover its fixed financial costs. Since financial leverage depends on fixed financial cost, high fixed financial costs indicates higher degree of operating leverage and thus, high financial risk. High financial leverage is good when operating profit is rising and bad when it is falling.

Managing Risk Relationship between operating leverage and financial leverage is multiplicative rather than additive. Operating leverage and financial leverage can be combined in a number of different ways to obtain a desirable degree of total leverage and level of total firm risk.

Designing Appropriate Capital Structure Mix To design an appropriate capital structure mix or financial plan, the amount of EBIT under various financial plans, should be related to earning per share. One widely used means of examining the effect of leverage to analyze the relationship between EBIT and earning per share.

Increase Profitability Leverage is an effort or attempt by which a firm tries to show high result or more benefit by using fixed costs assets and fixed return sources of capital. It insures maximum utilization of capital and fixed assets in order to increase the profitability of a firm, It helps to know the reasons not having more profit by a company.