Leverage: Meaning of Leverage and Importance of Leverage Analysis

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Topics to be Covered Are

  • Meaning of leverage
  • Importance of Leverage Analysis
  • Business and Financial Risk
  • Operating Leverage
  • Financial Leverage
  • Difference between Operating and Financial Leverage
  • Combined Leverage

Meaning of Leverage

Meaning of Leverage

Leverage refers to the ability of the firm to employ long-term funds having a fixed cost to enhance return to the owners.

Importance of Leverage Analysis

  • It helps in taking investment decisions.
  • It helps in taking financial decisions.
  • It helps in measuring business and financial risks.
  • It helps in maximising the wealth of shareholders.

Business and Financial Risk

  • Business Risk: Business risk refers to all hazards inherent in the operation of the business itself. Hence it is also known as operating risk. Business risk hazards may be due to fire, labour unrest etc.
  • Financial Risk: Financial risk refers to the variability in earnings of the equity shareholders and the additional risk of insolvency borne by the equity shareholders due to the use of financial leverage.

Difference between Business Risk and Financial Risk

Business Risk and Financial Risk
Business Risk and Financial Risk

Operating Leverage (OL)

Operating leverage is the firm՚s ability to use fixed operating costs to magnify the effect of changes in sales on its EBIT. When fixed costs are there in the cost structure, percentage change in profits is more than the percentage change in sales volume. Operating leverage is the relationship between the firm՚s sales revenue and its earnings before interest and tax (EBIT) .

Operating Leverage

Or

The alternative way to calculate degree of operating leverage (DOL) is

DOL

Financial Leverage (FL)

  • Financial leverage is the use of borrowed money (debt) to finance the purchase of assets with the expectation that the income or capital gain from the new asset will exceed the cost of borrowing.
  • Financial Leverage relates to the financing decisions of the firm. Financial leverage results from the existence of fixed financial charges in the firm՚s income stream. These charges do not change with the change in EBIT.
  • Financial Leverage is the relationship between EBIT and EPS. It measures the effect of change in EBIT on the level of EPS.

Financial Leverage

Or

Degree of Financial Leverage (DFL) is:

(1) When capital structure consists of debt and equity capital:

Degree of Financial Leverage (DFL)

(2) When capital structure consists of Debt, Preference and Equity capital:

Degree of Financial Leverage (DFL)

Where, DFL = Degree of Financial Leverage

PD = Preference dividend

t = Tax rate

I = Financial charges i.e.. interest

Difference between Operating Leverage and Financial Leverage

Operating Leverage and Financial Leverage
Operating Leverage and Financial Leverage

Combined Leverage (CL)

A degree of combined leverage (DCL) is a leverage ratio that summarizes the combined effect that the degree of operating leverage (DOL) and the degree of financial leverage have on earnings per share (EPS) , given a particular change in sales. This ratio can be used to help determine the most optimal level of financial and operating leverage to use in any firm.

The Formula for the Degree of Combined Leverage is:

DCL = DOL x DFL or

DCL or

D

  • Where, DCL is degree of combined leverage
  • If a high degree of operating risk is attached with a business activity, then a low degree of financial risk would reduce the fluctuations in additional earnings due to change in sales. If the firm wants to choose higher degree of financial leverage to increase its earning per share, then it should go for lower operating leverage or should incur low level of fixed operating costs.

On the basis of existence of leverages, a firm can be classified into three situations:

  • Risky situation: A risky situation is one where a firm is having both operating and financial leverage at a higher level.
  • Normal situation: A normal situation is one where one of these two leverages is high and other is low.
  • Ideal situation: An ideal situation is one where both these leverages are low.

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