What is Leverage? Types and Importance

What is Leverage?

Leverage results from using borrowed capital as a funding source when investing to expand the firm’s asset base and generate returns on risk capital. It 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. Leverage can also refer to the amount of debt a firm uses to finance assets. When one refers to a company, property or investment as “highly leveraged” it means that item has more debt than equity.

According to Ezra Solomon__ “Leverage is the ratio of net returns on shareholders equity and the net rate of return on capitalisation”.

Leverage types

Types of Leverage

  1. Operating leverage
  2. Financial leverage
  3. Combined leverage

1. Operating Leverage

It refers to the use of fixed operating costs such as depreciation, insurance of assets, repairs and maintenance, property taxes etc. in the operations of a firm. But it does not include interest on debt capital. Higher the proportion of fixed operating cost as compared to variable cost, higher is the operating leverage, and vice versa.

It is associated with operating risk or business risk. The higher the fixed operating costs, the higher the firm’s operating leverage and its operating risk. Operating risk is the degree of uncertainty that the firm has faced in meeting its fixed operating cost where there is variability of EBIT.

Importance

  1. It gives an idea about the impact of changes in sales on the operating income of the firm.
  2. It magnifies the effect on EBIT for a small change in the sales volume.
  3. It indicates increase in operating profit or EBIT.
  4. It results from the existence of a higher amount of fixed costs in the total cost structure of a firm which makes the margin of safety low.
  5. It indicates higher amount of sales required to reach break-even point.

2. Financial Leverage

It 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, debentures, bonds etc. and preference share capital.

According to Gitman It is “the ability of a firm to use fixed financial charges to magnify the effects of changes in EBIT on firm’s earnings per share”. In other words, It involves the use of funds obtained at a fixed cost in the hope of increasing the return to the equity shareholders.

Favourable or positive financial leverage occurs when a firm earns more on the assets/ investment purchased with the funds, than the fixed cost of their use. Unfavorable or negative leverage occurs when the firm does not earn as much as the funds cost.

It is associated with financial risk. Financial risk refers to risk of the firm not being able to cover its fixed financial costs due to variation in EBIT. With the increase in financial charges, the firm is also required to raise the level of EBIT necessary to meet financial charges. If the firm cannot cover these financial payments it can be technically forced into liquidation.

Importance

  1. It helps the financial manager to design an optimum capital structure. The optimum capital structure implies that combination of debt and equity at which overall cost of capital is minimum and value of the firm is maximum.
  2. It increases earning per share (EPS) as well as financial risk.
  3. A high financial leverage indicates existence of high financial fixed costs and high financial risk.
  4. It helps to bring balance between financial risk and return in the capital structure.

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. It measures the effect of a percentage change in sales on percentage change in EPS.

Importance

  1. It indicates the effect that changes in sales will have on EPS.
  2. It shows the combined effect of operating and financial leverage.