Leverage is the means using which a business firm can increase profits. The force will be applied on debt, the benefit of this reflected in the form of higher returns to equity shareholders. In simplae words, leverage is an investment strategy of using borrowed money—specifically, the use of various financial instruments or borrowed capital—to increase the potential return of an investment.
Following are the types of leverages:
1. Financial leverage: Financial leverage is primarily concerned with the financial activities which involve raising of funds from the 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. Financial leverage signifies the relationship between the earning power of equity and interest rate on borrowed capital.
2. Operating leverage: Operating leverage occurs when a firm incurs fixed costs which are to be recovered out of sales revenue irrespective of the volume of business in a period. In a firm having fixed costs in the total cost structure, a given change in sales will result in a disproportionate change in the operating profit or EBIT of the firm. It shows the ability of the firm to use fixed operating cost to increase the effect of change in sales on its operating profits.
3. Combined leverage: Both operating and financial leverages are closely concerned with ascertaining the firm’s ability to cover fixed costs or fixed rate of interest obligation, if we combine them, the result is total leverage and the risk associated with combined leverage is known as total risk. This leverage shows the relationship between a change in sale and the corresponding change in taxable income.
Leverage is a doubledouble-edged sword. It magnifies profits as well as losses. An aggressive or highly leveraged firm has high fixed costs and a conservative or non-leveraged firm has low fixed costs.
Following are the types of leverages:
1. Financial leverage: Financial leverage is primarily concerned with the financial activities which involve raising of funds from the 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. Financial leverage signifies the relationship between the earning power of equity and interest rate on borrowed capital.
2. Operating leverage: Operating leverage occurs when a firm incurs fixed costs which are to be recovered out of sales revenue irrespective of the volume of business in a period. In a firm having fixed costs in the total cost structure, a given change in sales will result in a disproportionate change in the operating profit or EBIT of the firm. It shows the ability of the firm to use fixed operating cost to increase the effect of change in sales on its operating profits.
3. Combined leverage: Both operating and financial leverages are closely concerned with ascertaining the firm’s ability to cover fixed costs or fixed rate of interest obligation, if we combine them, the result is total leverage and the risk associated with combined leverage is known as total risk. This leverage shows the relationship between a change in sale and the corresponding change in taxable income.
Leverage is a doubledouble-edged sword. It magnifies profits as well as losses. An aggressive or highly leveraged firm has high fixed costs and a conservative or non-leveraged firm has low fixed costs.
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