Leverages

Leverages

Leverage refers to ―an increased means of accomplishing some purpose‖. Leverage allows us to accomplish certain things which are otherwise not possible, viz lifting of heavy objects with the help of leverages.

In financial management , the term ‗leverage‘ is used to describe the firm‘s ability to use fixed cost asset or funds to increase the return to its owners i.e, Equity shareholders.

The employment of an asset or sources of funds for which the firm has to pay a fixed cost or fixed return. The fixed cost is also called as fixed operating cost and the fixed return is called financial cost remains constant irrespective of the change in volume of output of sales

Higher the degree of leverage, higher is the risk as well as return to the owner.

1.     Financial leverage or Trading on equity

2.     Operating leverage

3.     Combined leverage or composite leverage

1 Financial leverage

Leverage activities with financing activities is called financial leverage. Financial leverage represents the relations hip 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‖.

Financial leverage may be favourable or unfavourable depends upon the use of fixed cost funds. Favourable financial leverage occurs when the company earns more on the assets purchased with the funds, then the fixed cost of their use. Hence, it is also called as positive financial leverage.

Unfavourable financial leverage occurs when the company does not earn as much as the funds cost. Hence, it is also called as negative financial leverage.

Financial leverage can be calculated with the help of the following formula:

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

Alternative Definition of Financial Leverage

According to Gitmar, ―financial leverage is the ability of a firm to use fixed financial

changes to magnify the effects of change in EBIT and EPS‖.

FL = Financial Leverage

EBIT = Earning Before Interest and Tax

EPS = Earning Per share.

2 Uses of Financial Leverage

 Financial leverage helps to examine the relationship between EBIT and EPS.

 Financial leverage measures the percentage of change in taxable income to the percentage change in EBI T.

 Financial leverage locates the correct profitable financial decision regarding capital structure of the company.

 Financial leverage is one of the important devices which is used to measure the fixed cost proportion with the total capital of the company.

 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.

 The impact of financial leverage can be understood with the help of the following exercise.

3 Operating leverage

The leverage associated  with investment activities  is called as operating leverage.

Operating leverage can be calculated with  the  help of the following  formula:

W here,

OL = Operating Leverage

C = Contribution

OP = Operating Profits

Uses of Operating Leverage

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.

If any change in the sales, it will lead to corresponding changes in profit. Operating leverage helps to identify the position of fixed cost and variable cost.

 Operating leverage measures the relationship between the sales and revenue of the company during a particular period.

 Operating leverage helps to understand the level of fixed cost which is invested in the operating expenses of business activities.

 Operating leverage describes the over all position of the fixed operating cost.

DISTINGUISH BETWEEN OPERATING LEVERAGE AND FINANCIAL LEVERAGE

Operating Leverage

Operating leverage is associated with investment activities of the company.

Operating leverage consists of fixed operating expenses of the company.

It represents the ability to use fixed operating cost.

A percentage change in the profits resulting from a percentage change in the sales is called as degree of operating leverage.

Trading on equity is not possible while the company is operating leverage.

Operating leverage depends upon fixed cost and variable cost.

Tax rate and interest rate will not affect the operating leverage.

Financial Leverage

Financial leverage is associated with financing activities of the company.

Financial leverage consists of operating profit of the company.

It represents the relationship between EBIT and EPS.

A percentage change in taxable profit is the result of percentage change in EBIT.

Trading on equity is possible only when the company uses financial leverage.

Financial leverage depends upon the operating profits.

Financial leverage will change due to tax rate and interest rate.

Composite leverage

Combination of operating &financial leverage is called composite leverage

Working Capital Leverage

One of the new models of leverage is working capital leverage which is used to locate the investment in working capital or current assets in the company.

Working capital leverage measures the sensitivity of return in investment of charges in the level of current assets.