Leverage refers to the employment of assets or sources of fund bearing fixed payment to magnify EBIT or EPS respectively. So it may be associated with investment activities or financing activities.
What is Leverage?
In finance, leverage is a strategy that companies use to increase assets, cash flows, and returns, though it can also magnify losses. There are two main types of leverage: financial and operating. To increase financial leverage, a firm may borrow capital through issuing fixed-income securities or by borrowing money directly from a lender.
Operating leverage can also be used to magnify cash flows and returns, and can be attained through increasing revenues or profit margins. Both methods are accompanied by risk, such as insolvency, but can be very beneficial to a business.
How does leverage work?
If and when your business is ready to increase its scale of operations, expand into new markets, or update existing infrastructure, you’re going to need funds.However, if you don’t have enough equity or cash upfront, you’ll have to borrow funds.
Two ways to borrow capital are to issue bonds (equity financing) or borrow directly from lenders (debt financing).
Equity financing involves selling your equity in exchange for funding. One of the biggest benefits of equity financing is that it doesn’t lead to the company having to make interest payments or any principal repayment. Some of the most common examples of equity financing are initial public offerings (IPOs) and crowdfunding.
Debt financing involves a company borrowing money to fund working capital requirements. When a company borrows money, it needs to make interest payments as well as repay the principal. Taking a loan is a common debt financing example.
The 3 main types of leverage
Financial leverage refers to the amount of debt a business has acquired. On a balance sheet, financial leverage is represented by the liabilities listed on the right-hand side of the sheet.
Financial leverage lets your business continue to make investments even if you’re short on cash. It’s usually preferred to equity financing, as it lets you raise funds without diluting your ownership.
How to calculate financial leverage
You can determine the degree of financial leverage your business has through the debt-to-equity ratio. This ratio represents the proportion of assets your business has compared to its shareholders’ equity.
The formula is:
Let’s assume your total assets for the current year are $100,000, and for the previous year, they were $90,000. Your average total assets would then be:
(100,000 + 90,000)/2 = $95,000
You can calculate average total equity the same way.
A financial leverage ratio of 1 indicates no leverage. The higher the ratio, the more leveraged your business is and the riskier your capital structure.
Operating leverage accounts for the fixed operating costs and variable costs of providing goods and services. As fixed assets don’t change with the level of output produced, their costs are constant and must be paid regardless of whether your business is making a profit or experiencing losses. On the other hand, variable costs change depending on the output produced.
You can determine operating leverage by finding the ratio of fixed costs to variable costs. If your business has more fixed expenses than variable expenses, it has high operating leverage. You can use a high degree of operating leverage to magnify your returns, but too much of it can increase your financial risk.
How to calculate operational leverage
As mentioned, operating leverage is the ratio of its fixed costs to its variable costs. You can calculate this using the formula:
Let’s look at the hypothetical accounts for Business A and Business B,
Business A and Business B have a similar income statement structure; the only difference is that Business A has higher fixed costs than Business B. This implies a higher degree of operating leverage for Business A.
Therefore, Business A has higher operating leverage than Business B.
When demand is high and sales increase, profits rise by a more significant percentage for Business A than Business B. The average cost per unit also decreases by a greater amount for Business A than for Business B.
In contrast, when sales stagnate, Business A suffers more than Business B. Profits for Business A decline more than they do for Business B, and the average cost per unit rises for Business A more than it does for Business B.
Operating leverage can be used by businesses that have a large number of fixed assets. For example, capital-intensive companies, such as steel production, car manufacturing, and oil extraction, can leverage their fixed assets to reduce the average cost per unit and increase Earnings Before Interest and Tax (EBIT).
Combined leverage accounts for your organization’s total business risks. As the name suggests, combined leverage aggregates the effects of operating and financial leverages to present a complete picture of your company’s financial health.
Combined leverage can be used by capital-intensive businesses with expansion potential but insufficient levels of cash or equity. To effectively use combined leverage though, be sure of your business’s future expenses and the market conditions. High levels of combined risk can make returns susceptible to inputs, such as sales volumes.
How to calculate combined leverage
Combined leverage is the sum of operating and financial leverage. You can calculate it using the formula:
Financial leverage and operating leverage are both basic in their own terms. Furthermore, the two of them help organisations in creating better returns and lessen costs. So the inquiry remains can a firm utilise both of these influences? The response is yes.
On the off chance that an organisation can utilise its fixed costs well, it would have the option to create better returns just by utilising operating leverage. Furthermore, simultaneously, they can utilise financial leverage by changing their capital design from absolute value to 50-50, 60-40, or 70-30 value obligation extent or the debt proportion. Regardless of whether changing the capital structure would incite the organisation to pay interests, still, they would have the option to create a superior pace of profits and would have the option to lessen how much taxes they are to pay simultaneously.
That is the reason utilising financial leverage, and operating leverage is an extraordinary method for working on the rate of return of profits of the organisation and in lessening the expenses during a specific period.