2. The dictionary meaning of the firm leverages
refers to "an increase means of accomplishing
purpose".
In machines, leverages means the instrument that
helps us in lifting heavy objects, which may not
be other wise possible.
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LEVERAGE
5. In financial Management the term ‘Leverage’ is used
to describe the firms ability to use fixed cost assets
or funds to magnify the return to its owners.
James Horne defines leverage as;
“The employment of an asset or source funds for
which the firm pays a fixed cost or a fixed return”
In business language, if a firm has fixed expenses in
P/L account or debt in capital structure, the firm is
said to be levered.
LEVERAGE IN THE AREA OF FINANCE
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6. There are 3 types of leverages Viz;
1. Operating Leverage
2. Financial Leverage
3. Composite Leverage
The leverage associated with the employment of fixed cost
asset is referred to as operating leverage, While the leverage
resulting from the use of fixed cost/return source of fund is
known as financial leverage. Composite leverage focus on
the entire income of the concern.
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TYPES OF LEVERAGES
7. Operating leverage may be defined as the tendency of
the operating profit(EBIT) to vary disproportionately
with sales. Operating leverage is said to exist when a
firm has to pay fixed cost regardless the volume of
output or sales.
Operating leverage in a firm is a function of 3 factors
1. The amount of Fixed cost
2. The Contribution margin (S-V)
3. The volume of sales
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OPERATING LEVERAGE
9. Operating leverage increases with fixed cost.
Operating profit of a highly levered firm would
increase at a faster rate for any given increase in
sales. However if sales fall, the firm with a high
operating leverage would suffer more loss than the
firm with no or low operating leverage. hence it is
said that operating leverage is a double edged sword.
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OPERATING LEVERAGE IS A ‘DOUBLE
EDGED SWORD’
10. Profit fluctuations occurring due to high fixed
cost are referred to as operating risk. Operating
leverage is an important determinant of operating
risk.
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OPERATING RISK
11. Financial leverage may be defined as the tendency of the
residual net income (PBT) to vary disproportionately with
operating profits (EBIT).
It indicates the change that takes place in the taxable
income as a result of a change in the operating income.
It signifies the existence of fixed interest and or fixed
dividend bearing securities in the total capital structure of
the company.
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FINANCIAL LEVERAGE
12. In other words the use of fixed interest or dividend bearing
securities such as debt and preference capital along with the
owners equity in the total capital structure of the company is
defined as financial leverage.
Favorable financial leverage
Unfavorable financial leverage
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FINANCIAL LEVERAGE CONTD…
13. The use of fixed charges sources of fund such as debt
and preference capital along with the owners equity
in the capital structure is called trading on equity or
financial leverage or gearing
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TRADING ON EQUITY / GEARING
14. Financial leverage = Operating Profit(EBIT)
Taxable Income (PBT)
Degree of FL = % change in taxable income
% change in operating profit
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FINANCIAL LEVERAGE CONTD…
15. Operating Leverage Financial Leverage
Operating leverage is concerned with
investment activities of the firm.
Financial leverage is concerned with
financing activities of the firm.
It is the firm’s ability to use fixed operating
costs to magnify the effects of changes in
sales on its earnings before interest and taxes.
It is the firm’s ability to use fixed financial
charges to magnify the effects of changes in
EBIT on tis earnings per share
It is determined by the cost structure of the
firm.
It is determined by the capital structure of the
firm.
The higher the proportion of fixed operating
costs to the total operating costs in the cost
structure of a firm, the higher is the degree of
operating leverage
The higher the proportion of fixe charges
bearing capital to total financial changes in
the capital structure of a firm, the higher is
the degrees of financial leverage.
Degree of operating leverage measure the
business risk associated with the firm
Degree of financial leverage measure the
degree of financial risk, associated with the
firm.
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DIFFERENCE BETWEEN FINANCIAL
LEVERAGE AND OPERATING LEVERAGE
16. Combined leverage is the leverage obtained by combining
operating leverage and financial leverage. Composite
leverage discloses the effect of change in sales on taxable
profit ie; EPS
Composite leverage expresses the relationship between
revenue on account of sales (ie; contribution) and taxable
income. It helps in finding out the percentage change in
taxable income on account of percentage change in sales.
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COMBINED LEVERAGE/ COMPOSITE LEVERAGE
