Accounts Notes: What is Leverage

Tuesday, 5 April 2011

What is Leverage

It arises from the presence of fixed cost in a firm capitalstructure.
Generally leverage refers to a relationship between two interrelated variables.
These leverages are classified into three types.
1. Operating leverage
2. Financial Leverage.
3. Combined leverage or total leverage.

1. Operating Leverage: It arises from fixed operating costs (fixed costs other than the financing costs) such as depreciation, shares, advertising expenditures and property taxes.

When a firm has fixed operatingcosts, a change in 1% in sales results in a change of more than 1% in EBIT
%change in EBIT
% change in sales

The operaying leverage at any level of sales is called degree.
Degree of operatingLeverage= Contribution/EBIT

Significance: It tells the impact of changes in sales on operating income.
If operating leverage is high it automatically means that the break- even point would also be reached at a highlevel of sales.

2. Financial Leverage: It arises from the use of fixed financing costs such as interest. When a firm has fixed cost financing. A change in 1% in E.B.I.T results in a change of more than 1% in earnings per share.
F.L =% change in EPS / % change in EBIT
Degree of Financial leverage= EBIT/ Profit before Tax (EBT)
Significance: It is double edged sword. A high F.L means high fixed financial costs and high financial risks.

3. Combined Leverage: It is useful for to know about the overall risk or total risk of the firm. i.e, operating risk as well as financial risk.
C.L= O.L*F.L
= %Change in EPS / % Change in Sales
Degree of C.L =Contribution / EBT

A high O.L and a high F.L combination is very risky. A high O.L and a low F.L indiacate that the management is careful since the higher amount of risk involved in high operating leverage has been sought to be balanced by low F.L
A more preferable situation would be to have a low O.L and a F.L