What is Leverage?

The term leverage is defined as the employment of an asset or sources of funds for which the company has to pay a fixed cost or fixed return. Consequently, the earnings available to the shareholders as also the risk are affected. If earnings less the variable costs exceed the fixed cost, or the earnings before interest and taxes exceed the fixed return investment, the leverage is called favourable, if they do not, the leverage is unfavourable.

There are two types of leverage – ‘operating’ and ‘financial’. The leverage associated with investment (asset acquisition) activities is referred to as operating leverage, while leverage associated with financing activities is called financial leverage.

Operating Leverage

The operating leverage is defined as the company’s ability to use fixed operating costs to magnify the effects of changes in sales on its earnings before interest and taxes (EBIT). In other words, operating leverage leads to more than a proportionate change (±) in operating profits as a result of given change in the sales volume. Higher the fixed operating cost of a company, the higher the company’s operating leverage and its operating risk. The operating leverage can be favourable when increase in sales volume has a positive magnifying effect on operating profits and it is unfavourable when a decrease in sales volume has a negative magnifying effect on operating profits. Therefore, high operating leverage is good when sales revenues are rising and bad when they are falling. The degree of operating leverage has implications for the business risk of the company. An important technique to analyse operating leverage is break- even analysis.

Financial Leverage

The financial leverage is defined as the ability of a company to use fixed financial charges to magnify the effects of changes in earnings before interest and taxes on the company’s earnings per share (EPS). In other words, financial leverage involves the use of funds obtained at a fixed cost (like bonds and preferred stock) in the hope of increasing the return to the shareholders. Like the operating leverage, financial leverage can be positive when operating profits are increasing and can be negative in the situation of decrease in operating profits. The financial leverage affects the financial risk of the company. An important analytical tool for financial leverage is the indifference point at which the EPS/market price is the same for different financial plans under consideration.

As a general rule debt/equity of more than 100% or debt/capital employed of more than 50% is "high", but there is no cut-off point that is too high. As debt gets higher, profits for shareholders become more volatile. A high level of debt is a cause for concern, but it does accelerate profit growth as well as declines. Companies with more stable operating profits can safely take on higher levels of debt, so what is acceptable depends on the business. However, in periods of persisting adversity when earnings are not adequate, the presence of fixed charges will imply that the shareholders will have to bear the burden.