Leverage: Meaning, Definition and Type of Leverage

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Leverage
Leverage

In the world of finance, the word “leverage” has various variables such as revenue, costs, earnings before interest and tax (EBIT) and output quantity that has an impact on the returns available to the shareholders. The study of leverage involves the quantification of the inter-relationship between two or more variables.

The formula for calculating leverage:

Leverage= % Change in Dependent Variable / %Change in Independent Variable

According to Ezra Solomon, “Leverage is the ratio of the net rate of return on shareholders equity and the net rate of return on total capitalization”.

Role of Fixed Cost in Leverage

The roles of fixed cost in leverage are explained below:

1) In order to earn a greater extent of profit, leverages are used by the organization once it becomes a well-established entity and when is an upswing in the profit earning resulting from the manufacturing of products.

2) With the increasing production of the products, the installed machines are used more efficiently and fixed costs are fairly distributed.

3) The cost in which there is no variation due to the operation level is termed as a fixed cost. There will be no change in the fixed cost with increasing sales. For greater quantities of products, there will be no change in the margin however there will be an increase in the overall profit and margin of the organization.

4) The leverage can be seen as the measurement mode which helps the organizations to have increased fixed cost. There is a direct relation between the fixed costs and production overheads, interest cost and so on. The point to notice is that it is more related to fulfilling the liability cost rather than the operation level.

5) If the fixed cost is present, the rate of change in profit will be more than the rate of change in the sales volume. There will be no operating leverage for the organization without any type of fixed cost. There will be a similarity between the rate of change in sales and the rate of change in profit.

Types of Leverage

The main types of leverage and their various characteristics are as follows:

1)  Operating

Operating leverage is related to the cost structure of a firm. It uses fixed costs incurred by the firm to maximize the returns. A cost is considered to be fixed when it remains the same even with the change in the output, in short, fixed costs are not affected by the change in production volume. Operating makes use of these characteristics to make appropriate decisions.

operating leverage results when there is a change in the operating profit of the firm due to the change in sales revenue. The degree of change is determined by the quantum of fixed costs. Operating occurs when the change in sales revenue brings about more than a proportional change in operating profits.

This type of leverage may use cost-volume-profit analysis or break-even analysis for this purpose.

Operating Leverage = Contribution or (Sales— Variable Cost) / Operating Profit or (Contribution — Fixed Cost)

According to Brigham, “If a high percentage of a firm’s total costs are fixed costs, then the firm is said to have a high degree of operating leverage”.

Characteristics of Operating

The following are the salient characteristics of operating leverage:

  • Importance of Fixed Costs: Operating leverage depends on the existence of fixed costs. If there are no fixed costs, there cannot be operating leverage for that business.
  • Direct Relationship between Operating Leverage and Break-Even Point: The degree of operating leverage is highly close to the break-even point. Therefore, it shows that there is a direct connection between the operating profit and break-even point.

Financial

The Financial Leverage is related to the financial structure of the firm. Financial leverage is also known as trading on equity. It is concerned with the use of financial instruments with fixed costs or returns to maximize EBIT. Financial is higher for the firms bending towards fixed charge financial instruments. A firm can achieve high financial by making more use of financial products such as debentures and preference share capital which are bearing fixed costs. Such fixed financial costs lead to a higher than proportional change in its Earnings per Share (EPS), in response to change in its EBIT.

A firm with financial leverage of 2, will experience a 200% change in its EPS with every 100% change in its EBIT. Financial  determines the rate of change in a firm’s EPS due to change in its EBIT. This change exists due to fixed financial charges. A firm with nil fixed financial charges does not have financial.

According to J.E. Walter. “Financial may be defined as a percentage return on equity fixed on the percentage return on capitalization”.

If the rate of earning is equal to the rate of payment to be paid on a fixed income instrument, then it is the indifferent point.

Characteristics of Financial

The salient characteristics of financial leverage are given below:

  • Sources of Capital: Financial leverage is dependent on the composition of the liability side of the balance sheet. Firms with higher fixed cost securities display higher financial leverage.
  • Based on Fixed Cost Capital: Financial leverage is dependent on the existence of fixed cost capital. No fixed cost capital. no financial leverage.
  • Direct Relation between Financial Leverage and Risk: Higher financial leverage indicates higher financial risk and vice versa.

Combined/Composite

Composite leverage is the amalgamation of operating leverage and financial leverage. On the other hand, financial leverage is concerned with the effect of the percentage change in operating profit or EBIT on EPS. In this way, the leverage defines the degree of financial risk undertaken by the firm. Composite is used to describe the interrelationship between sales revenue and taxable income.

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