6

Meaning of Leverage
Leverage helps us in lifting heavy material or object, which may
not be otherwise possible. However in area of finance, the term
refers to the ability of a firm in employing long-term fund having a
leverage'
fixed cost, to enhance returns to the owners. In other words,
is the employment of fixed assets or funds for which a firm has to
leverage'
meet fixed costs or fixed rate of interest
obligation irrespective of the
level of activities attained or the level of operating profit earned. James
Horne has defined leverage as "the employment of an asset or funds
for which the firm pays a fixed cost or fixed return". Thus
to him leverage results for
according
using an fixed asset or sources of funds
which has fixed costs. The former may be termed as 'fixed
operating
cost while the latter may be termed, as 'fixed financial costs'. Here the
fixed cost or the fixed return acts as the falcrum of leverage. Without
the fixed cost orfixed return there will be no leverage.
Since fixed cost or fixed return does not have any relationship
with level of activity or volume of production or sales, the amount of
such cost or return has considerable impact over the amount divisible
profit to the shareholders. In other words higher the leverage, higher
the divisible profit and vice-versa. But a higher leverage obviously
implies higher outside borrowings and hence higher risk if the business
activity comes down. A high degree of leverage implies that there will
be a large change in profits due to a relatively small changes in sales
and vice-versa. Thus, higher is the leverage, higher is the risk and
higher is the expected return, The higher leverage may also magnify the
amount of losses, while the activity level i.e. volume of sales or volume
of production cannot meet fixed cost or fixed return with its profit.

TYPES OF LEVERAGE
There are three types of leverage:
(a) Operative Leverage or Operating Leverage
(b) Financial Leverage
(c) Composite or Combined Operating and Financial Leverage
 6.2
It refers to the use
of fixed costs in
(a) Operating Leverage firm has a high degree of operating
the operation of
the firm. A
a greater
amount of fixed cost (and a Sm small
leverage if it employs
amount of variable costs.)
On the other hand, if the firmn (incurs
(incurs a
small amount of fixed coct
greater amount of
variable cost) employs a osts,
leverage. The profits of a high
it has a low degree of operating
rate than the increace
leveraged (operating)firm will increase at a faster e
in sales. However, if the sales fall, the firm with a high degree of

operating leverage will suffer a greater loss than a firm with low
moderate degree of operating leverage.
Operating leverage in a firm is a function of three factors
1. The amount of fixed costs
2. The contribution margin i.e. (Sales minus variable cost)
3. The volume of sales.
Definition:
1. "Operating leverage exists when changes in revenue produce
greater changes in EBIT: -John Hampton
2. "Operating leverage is the tendency of the operating profit to
vary disproportionately with sales". -Soloman lzra
Measures or Computation of Operating Leverage
Operating Leverage = Contribution
Operating Profit
Operating profit means "Earning Before Interest and Taxes" (EBIT).
Operating leverage may be favourable or unfavourable. In case the
contribution (Sales minus variable cost) exceed the fxed cost, there is
favourable operating leverage. In case the contribution does not exceed
the fxed cost, the operating leverage will be termed as unfavourable.
Degree of operating leverage : The degree of operating leverage
may be defined as the percentage change in profts resulting from a
percentage change in sales. The same may be expressed in equation
form
Degree of operating leverage Percentage change in profits
Percentage change in sales
llustratian 1
Characteristics of Operating Leverage
The chief characteristics of operating leverage are as under
(1) Related to fixed costs-If there are fixed costs in the firm
there will be operating leverage and it tells us that the change in sales
will bring more change in operating profits or EBIT
(2) Highest operating leverage near break-even point-There is
direct relation between operating profit and break-even point. At
break-even point there is no profit no loss. The degree of operating
leverage is highest near B.E.P.
(3) Business risks-On the one side the operating leverage raises
operating profits but on the other side it raises business risks of
increasing losses. Because if operating leverage is high a small fall in
sales will result in very high reduction in operating profit.
The effect of operating leverage on high
profit: if firm has a
a
degree of operating leverage, small changes in sales will have large
effect on operating income. In other words, the operatng profits (EBIT)
of such a firm will increase at a faster rate than the increase in sales.
Similarly, the operating profits of such a firm will suffer a greater rate
when there is a decrease in its sales.
Generally, the firms do not like to operate under conditions of
a high degree of operating leverage. This is a very risky situation where
a small drop in sales can be excessively damaging to the firm's efforts
to achieve profitability.
 FINANCIAL LEVERAGE

A company can raise its funds from a variety of sources, such

as debt, preference share capital and equity share capital, including
reserves and surplus. The rate of interest on debt is fixed irrespective
of the company's rate of return on assets. The company has a legal
binding to pay interest on debt. The rate of preference dividend 1S
also fixed, but the preference dividends are paid when the company
residual
earns profits. The equity shareholders are entitled
to the
income. The rate of the equity dividend is not fixed and depends on
the dividend policy of the company.
 6.8
such as deht
The use of the fixed charges sources of funds,
in the capital struct
preference capital along with the owners' equity
is described as financial leverage or trading on equity. Financial rage
means increasing the profitability of the firm by using fixed cost beariing
finance.
The use of the term "trading on equity" is derived from the fact
that it is the owners' equity (capital) measured by equity share capit
and reserves and surpluses that is used as basis to raise debt and

preference capital.
The financial leverage employed by a company is intended to
earn more on the fixed charges funds than their costs. The surplus will
increase the return on equity share capital i.e. the rate of return on
the owners' equity is levered above the rate of return on total assets,
Thus financial leverage means increasing the profitability of the firm
by using fixed cost financing.

Definition
1. "Financial Leverage exists whenever a firm has debts or other
sources of funds that
carry fixed charges." - Hampton

2. Ability of a firm to use fixed financial charge to magnify the

effects of changes in EBIT on the firms earning per share is financial
leverage." - Gitman

3. "Financial leverage involves the use of funds obtained at a

fixed cost in the hope of increasing the return to common stockholders."
-James C. Vane Horn
The financial leverage can be high or low. If the preparation of
fixed cost capital is high, it will have a high inancial leverage and if
the proportion of variable cost capital is high, there will be low financial
leverage.If a company is having low proportion of variable cost capital
and high proportion of fixed cost capital, this. situation is also known
as trading. on equity. The firm should use more of fixed cost capital
if the rate of carnings in the firm is higher than the cost of debt capital
and if earnings rate is low, the firm should use more of equity capital.
The financial leverage may be favourable or unfavourable. If the
cost of borrowed funds is less than the overall return of funds, it will
be lavourable financial leverage and otherwise it will be unfavourable,
i.e. il the overall return is less than the cost of borrowed capital.
Efect of Finaneial Leverage on the Shareholder Earning: The
primary motive of a company is using financial leverage is to magnily
the shareholders' earnings under favourable economic conditions. The
role of financial leverage in magnifying the earnings of the shareholders
is based on the assumption that the fixed charges funds can be obtainecu
Meaning of Leverage
6.9
ta cOSt lower than the company's rate of return
on its
the difference between the
earnings generated by assets assets. Thus.S,
the fixed charges funds and the costs of these funds is
financed by
hareholders, they get additional earnings without distributed to
estments. Consequentiy, the carnings per share or theincreasing
rate of
their
hecommon sharholder's equity increases. However,
return
the earnings
per share
re or the rate of return on equity will fall if the
htains the fixed charges funds at a cost higher than
the rate of return
company
on the company's assets. The earnings
per share (EPS) and the rate
of return on equity are important figures for analysing the
impact of
financial leverage.
 1, uITCTO, tIere IS no presence or Iinanc1al
levErage.
Characteristics of Financial Leverage
Following are the main characteristics
) Related to fixed cost capital If there is fixed
no cost capital
-

then there will be no financial leverage.

(ii) Related with liabilities side of the balance sheet-It is
concerned with the liabilities side of the balance sheet where different
ype of sources of capital are shown.
Meaning o Leverage
6.17
s Shows effects or changes in Iixed charges on
shows the effects of changes in fixed costs on EPS-Financial
leverage EPS of the firm.
(iv) Rinancial risk-The financial risk of the firm increases with
eence of financial leverage. with the increase in operating proit
ncreases proportionately more on account of financial leverage
likewise EPS declines more rapidly than decline in EBIT.
and