types of leverage

1. LEVERAGES
In Financial Management ,the term leverage is
used to describe the firms ability to use fixed cost
assets or funds to increase the return to its owners
James has defined leverage as the
employment of an assets 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 fixed return called as financial cost

2. FIXED COST
• It is also known as indirect cost or overhead
cost, are business expenses that are not
dependent on the level of goods or services
produced by the business. ( interest, rents,
salary paid per month)
• Variable cost changes as the quantity of goods
or services that a business produces changes (
direct labour cost, raw material etc)

4. FINANCIAL LEVERAGE
When purchasing assets, three options are available to the company for financing: using equity, debt, and
leases. Apart from equity, the rest of the options incur fixed costs that are lower than the income that
the company expects to earn from the asset. In this case, we assume that the company uses debt to
finance asset acquisition.
Assume that Company X wants to acquire an asset that costs $100,000. The company can either use
equity or debt financing. If the company opts for the first option, it will own 100% of the asset, and
there will be no interest payments. If the asset appreciates in value by 30%, the asset’s value will
increase to $130,000 and the company will earn a profit of $30,000. Similarly, if the asset
depreciates by 30%, the asset will be valued at $70,000 and the company will incur a loss of
$30,000.
Alternatively, the company may go with the second option and finance the asset using 50% common
stock and 50% debt. If the asset appreciates by 30%, the asset will be valued at $130,000. It means
that if the company pays back the debt of $50,000, it will have $80,000 remaining, which translates
into a profit of $30,000. Similarly, if the asset depreciates by 30%, the asset will be valued at
$70,000. This means that after paying the debt of $50,000, the company will remain with $20,000
which translates to a loss of $30,000 ($50,000 – $20,000).

5. OPERATING LEVERAGE
It implies use of fixed cost in the operation of a
firm. Every firm has to incur fixed cost
irrespective of the volume of production or
sales. Since fixed cost remains constant, even
a small change in sales brings about a more
than proportionate change in operating profit

6. Combined Leverage
• It establishes a relationship between sales and
the corresponding variation in taxable income.

7. Degree of Operating Leverage
OP LEVERAGE = Contribution/EBIT
Contribution = sales – Variable Cost
EBIT = Operating profit
DOL = % change in EBIT/% CHANGE IN SALES

8. Degree of Financial Leverage
• FL = EBIT/EBT
• DFL = % Change in EPS / % Change in EBIT