Concept of Leverage:
Leverage means use of assets and sources of funds having fixed costs in order to increase the potential returns to shareholders. The term Leverage,in general,reference to the relation ship between two interrelated variables. In financial matters,one financial variable influence another variable. Those financial variable may be cost,sales revenue,earnings before interest and tax,output,earnings per share. It is measurement of the relationship of the two variables,rather than on measuring the variables.
According to J. E. Walter, ‘Leverage may be defined as percentage return on equity and the net rate of return on total capitalization’.
According to James C. Van Horne,” Leverage may be defined as the employment of an asset of funds for which the firm pays cost or fixed return.The fixed costs or return may be thought of as the fulcrum of Lever”.
According to Ezra Soloman,” Leverage is the ratio of the net rate of return on shareholders equity and the net rate of return on total capitalization”.
The leverage used to describe the firm’s ability to use fixed cost assets or funds to increase the return to its owner. A high degree of leverage implies that a high variation in earning available to equity shareholders occurs due to a relatively small variation in sales.
Types of Leverage
1. Financial Leverage
Financial leverage is also known as trading on equity. Financial leverage results from the presence of fixed financial costs in the firm’s income stream. Financial leverage is the potential use of fixed financial costs to magnify the effects of the changes in earning before interest and taxes on the firm’s earnings per share.The two fixed financial cost that may be found on the firm’s income statement are:
- Interest on debt
- Preferred stock dividends.
According to J.E.Walter,” Financial leverage may be defined as percentage return on equity to the percentage return on capitalization“
Characteristics of financial leverage
- concern with liabilities side of the balance sheet: It is concerned with the liabilities side of the balance sheet where different type of sources of capital is shown.
- Related to fixed cost capital: If there is no fixed cost capital,there will no financial leverage.
- Financial risk: The financial risk of the firm increase with the presence of financial leverage.
2. Operating Leverage
Operating leverage may be defined as the firm’sability to use fixed operating costs to magnify the effect of changes in sales on its earning before interest and tax. The relationship between contribution margin and earning before interest and tax (EBIT) is called degree of operating leverage. It may be defined as the rate of changes in EBIT due to the change in the rate of sales. The firm operating with high fixed operating cost has higher degree of operating leverage. Higher levels of risk are attached to higher degree of leverage. High operating leverage is good when sales are increasing and bad when they are falling.
Operating leverage is used to measure the business risk. Business risk is the risk of the firm not being able to cover its fixed operating costs.
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 leverage
- Related to fixed costs: If there are fixed costs in the firm there will be operating leverage and if there are no fixed costs.There will be no operating leverage.
- Highest operating leverage near break-even point: There is direct relation between operating profit and break-even point.The degree of operating leverage is highest near BEP.
3.Total/ Combined Leverage
The combination of operating leverage and financial leverage is called total leverage or combined leverage. Operating leverage measures operating risk whereas financial leverage measures financial risks. Total leverage or combined leverage measures total risk of the business.
Operating leverage is measured by the percentage change in earning before interest and tax due to percentage change in sales where as financial leverage is measured by percentage change in earning per share due to percentage change in earning before interest and tax.
Composite leverage, thus,express the relationship between revenue on account of sales and the taxable income. It helps in finding out the resulting percentage change in taxable income on account of percentage change in sales.
This can be computed as follows:
C=Contribution,OP= Operating profit,PBT=Profit before tax but after interest.