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.
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: Commonly used leverages are of the following type :
1. 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. Operating leverage can be calculated with the help of the following formula:
OL = C/OP
Where ,
OL = Operating Leverage
C = Contribution
OP = Operating Profits
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. It can be calculated with the help of the following formula:
DOL = Percentage change in profits/Percentage change in sales
Uses of Operating Leverage
i. 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.
ii. If any change in the sales, it will lead to corresponding changes in profit.
iii. Operating leverage helps to identify the position of fixed cost and variable cost.
iv. Operating leverage measures the relationship between the sales and revenue of the company during a particular period.
v. Operating leverage helps to understand the level of fixed cost which is invested in the operating expenses of business activities.
vi. Operating leverage describes the over all position of the fixed operating cost.
2. Financial 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. Financial leverage can be calculated with the help of the following formula:
FL = OP/PBT
Where,
FL = Financial leverage
OP = Operating profit (EBIT)
PBT = Profit before tax.
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 (EBIT). This can be calculated by the following formula: DFL= Percentage change in taxable Income / Precentage change in EBIT.
Factors affecting financial leverage: (VVVI Section)
Financial leverage is PBIT/ PBT. Therefore as interest increases, financial leverage will increase. Interest, in turn, being the cost of borrowed funds, will increase with increase in the proportion of debt used for financing assets. That is why, the ratio of borrowings to assets is also called financial leverage. The higher the degree of financial leverage of a firm, the greater is the sensitivity of its profits before tax to changes in PBIT.
The combined leverage factor which is the product of operating leverage and financial leverage determines the overall sensitivity of profits before tax to change in sales. As income taxes are calculated as a percentage of profit before tax, the net profit will normally be proportionate to the profit before tax. Therefore, fluctuations in profit before tax will bring about corresponding fluctuations in net profits which in turn will bring about fluctuations in earnings per share (EPS) as EPS equals net profit divided by the number of equity shares. Therefore, the combined leverage factor influences the extent to which net profits and EPS will fluctuate for a given fluctuation in sales.
It is important to remember that additional benefits will accrue only when the return on assets is higher than the cost of borrowings. If however, the cost of borrowings is higher than the return on assets; the return on net worth will be even less than the return on assets.
Uses of Financial Leverage
i. Financial leverage helps to examine the relationship between EBIT and EPS.
ii. Financial leverage measures the percentage of change in taxable income to the percentage change in EBIT.
iii. Financial leverage locates the correct profitable financial decision regarding capital structure of the company.
iv. Financial leverage is one of the important devices which is used to measure the fixed cost proportion with the total capital of the company.
v. 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.
3. Combined 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. Combined leverage can be calculated with the help of the following formulas:
CL = OL × FL or CL =C / PBT
Where,
CL = Combined Leverage
OL = Operating Leverage
FL = Financial Leverage
C = Contribution
PBT= Profit Before Tax
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. Degree of contributed coverage = Percentage change in EPS / Percentage change in sales
Difference between Operating Leverage and Financial Leverage
1. Operating Leverage results from the existence of fixed operating expenses in the firm’s income stream whereas Financial Leverage results from the presence of fixed financial charges in the firm’s income stream.
2. Operating Leverage is determined by the relationship between a firm’s sales revenues and its earnings before interest and taxes (EBIT). Financial Leverage is determined by the relationship between a firm’s earnings before interest and tax and after subtracting the interest component.
3. Operating Leverage = Contribution/EBIT and Financial Leverage = EBIT/EBT
4. Operational Leverage relates to the Assets side of the Balance Sheet, whereas Financial Leverage relates to the Liability side of the Balance Sheet.
5. Operational Leverage affects profit before interest and tax, whereas Financial Leverage affects profit after interest and tax.
6. Operational Leverage involves operating risk of being unable to cover fixed operating cost, whereas Financial Leverage involves financial risk of being unable to cover fixed financial cost.
7. Operational Leverage is concerned with investment decisions, whereas Financial Leverage is concerned with financing decisions.
8. Operating Leverage is described as a first stage leverage, whereas Financial Leverage is described as a second stage leverage.