Leverage means the action of a lever and mathematical advantage gained by it.
Firm’s ability to use fixed costs assets or sources of funds to magnify the returns to its owners.
According to James Home, ‘ leverage is the employment of an asset or sources of funds for which the firm has to pay a fixed costs or fixed return.
Types of Leverage…
The firm’s ability to use operating cost to magnify the effects of changes in sales on its EBIT.
The degree of operating leverage may be defined as the change in the percentage of EBIT, for a given change in percentage of sales revenue.
Symbolically… When the data is given only for one year, then we have to compute operating leverage, by the following formula. Percentage change in Sales Or Percentage change in EBIT = Degree of Operating Leverage (DOL) Operating Profit (EBIT) Contribution = Operating Leverage
Application of the Operating Leverage…
It is helpful to know how operating profit would change with a given change in units produced.
It will be helpful in measuring business risk.
Ability of the firm to use fixed financial charges to magnify the effect of changes in EBIT on firm’s EPS.
Percentage change in EPS Percentage change in EBIT = Degree of Financial Leverage (DFL) EBT (Taxable income) Or EBIT (Operating profit) = Financial Leverage
Application of the Financial Leverage…
It is helpful to know how EPS would change with a operating profit.
It is helpful for measuring financial risk.
The percentage change in EPS due to the percentage changes in sales.
Or % Change in Sales % Change in EBIT % Change in Sales % Change in EPS = % Change in EPS X % Change in EBIT EBT EBT EBIT Contribution = EBIT X Contribution
Effect of Leverage… This combination is an ideal situation. The company can follow aggressive debt policy. High Low This combination have adverse effects of operating leverage were taken care of by having low financial leverage. Low High This combination is very cautious policy and not assuming risk. Low Low This combination is very dangerous policy, which should be avoided. High High Combined Effect Financial Leverage Operating Leverage