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Leverage
Leverage can be defined as the employment of an asset or source of funds for which the firm has to pay a
fixed cost or fixed return. Because of the incurrence of fixed costs, the net income and the earnings
available to the equity shareholders as well as the risk gets affected. Leverage is favorable when the
earnings less the variable costs exceed the fixed costs or when the earnings before interest and taxes
exceed the fixed return requirement. Leverage is unfavorable in the reverse situation.
Leverage can be of two types; Operating & Financial leverages.
1. Operating leverage - The leverage associated with investment, i.e., asset acquisition activities is
called as operating leverage. Breakeven analysis shows that there are essentially two types of costs in
a company's cost structure -- fixed costs and variable costs. Operating leverage refers to the
percentage of fixed costs that a company has. Stated another way, operating leverage is the ratio
of fixed costs to variable costs. If a business firm has a lot of fixed costs as compared to variable costs,
then the firm is said to have high operating leverage. These firms use a lot of fixed costs in their
business and are capital intensive firms. It is calculated as follows:
2. Financial Leverage - the leverage associated with financing activities is called as financial leverage.
Financial leverage can be aptly described as the extent to which a business or investor is using the
borrowed money. Business companies with high leverage are considered to be at risk of bankruptcy if, in
case, they are not able to repay the debts, it might lead to difficulties in getting new lenders in future. It is
not that financial leverage is always bad. However, it can lead to an increased shareholders return on
investment. Also, very often, there are tax advantages related with borrowing, also known as leverage.
Financial Leverage = Operating Profit Profit before tax but after interest