What is leverage? What do you mean by leverage?

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 The term leverage refers to an increased means of accomplishing some purpose. Leverage is used to lifting heavy objects, which may not be otherwise possible. In the financial point of view, leverage refers to finish the ability to use fixed cost assets or funds to increase the return to its shareholders.

Leverage can be classified into three major headings according to the nature of the finance mix of the company.

Leverage=Financial Leverage & operating Leverage, Composite leverage is mixture of Financial & Operating Leverage.

Operating Leverage: The leverage associated with investment activities is called as operating leverage. It is caused due to fixed operating expenses in the company. Operating leverage may be defined as the company’s ability to use fixed operating costs to magnify the effect of changes in sales on its earnings before interest and tax. Operating leverage consists of two important costs (Fixed cost and variable cost) when the company is said to have a high degree of operating leverage if it employs a great amount of fixed cost and smaller amount of variable cost

Operating leverage can be calculated with the help of following formula: 

Operating leverage = Contribution/Operating profit

The degree of operating leverage may be defined as percentage change in the profit resulting from a percentage change in the sales. It can be calculated with the help of the following.

Degree of operating Leverage= percentage of change in profit/Percentage of change in sa

Operating leverage = Contribution/Operating

Company A leverage: 12, 50,000/5, 00,000 =2.5

Company B leverage: 22, 50,000/7, 50,000 =3

Uses of operating leverage 

Operating leverage is one the technique to measure the impact of changes in sales which lead for change in the profit of the company.

If any change in sales, it will lead to corresponding changes in profit.

Operating leverage helps to identify the position of fixed cost and variable cost.

Operating leverage measures the relationship between the sales and revenue of the company during the particular period.

Operating leverage helps to understand the level of fixed cost which is invested in the operating expenses of business activities

Financial Leverage: Leverage activities with financial activities is called leverage. Financial leverage re-presents the relationship between company’s earnings before interest and taxes (EBIT) or operating profit and earnings available to equity shareholders.

Financial leverage is defined as the ability of a firm to use fixed financial charges to magnify the effect of changes in EBIT on the earnings per share. It involves the use of fund obtained at fixed cost in the hope of increasing the return to the shareholders. The use of long term fixed interest bearing debt and preference share capital along with share capital is called financial leverage or trading on equity.

Favourable financial leverage occurs when the company earns more on the assets purchased with funds, then the fixed cost of their use. Hence, it is also called as positive financial leverage.

Unfavourable financial leverage occurs when the company does not earn as much as the fud cost, hence it is called as negative financial leverage.

Financial leverage can be calculated with the help of the following formula:

Financial leverage = operating profit/profit before tax

Uses of financial leverage

Financial leverage helps to examine the relationship between EBIT and EPS.

Financial leverage measures the percentage of change in taxable income to the percentage change in EBIT.

Financial leverage locates the correct profitable financial decision regarding capital structure of the company.

Financial leverage is one of the important devices which is used to measure the fixed cost, earning per share and return on equity capital will decrease.

Combined leverage

When the company uses both financial and operating leverage to magnification of any change in sales into a larger relative changes in earning per share. Combine leverage is also called as composite leverage or total leverage.

Combine leverage express the relationship between the revenue in the account of sales and taxable income.

 Combine leverage can be calculated with help of following formula

Combined leverage = Operating leverage x financial leverage


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