Leverage Meaning, Types, Features, Uses, 8 Differences [Financial Management Notes for NEP and CBCS Pattern]

[Leverage Meaning, Leverage Types, Operating Leverage, Financial Leverage, Composite Leverage, Features, Uses, 8 Differences Between Operating Leverage and Financial Leverage]

Leverage Meaning

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 furnish the ability to use fixed cost assets or funds to increase the return to its shareholders.

James Horne has defined leverage as, “the employment of an asset or fund for which the firm pays a fixed cost or fixed return.

Leverage Types

Commonly used leverages are of the following type :

1) 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 effects of changes in sales on its earnings before interest and taxes. Operating leverage consists of two important costs viz., 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. Thus, the degree of operating leverage depends upon the amount of various cost structure. Operating leverage can be determined with the help of a break even analysis. Operating leverage can be calculated with the help of the following formula:

OL = C/OP

Where ,

OL = Operating Leverage

C = Contribution

OP = Operating Profits

Degree of Operating Leverage: The degree of operating leverage may be defined as percentage change in the profits resulting from a percentage change in the sales. It can be calculated with the help of the following formula:

DOL = Percentage change in profits/Percentage change in sales

Features of operating leverage

a) It is related to the assets side of balance sheet.

b) It is calculated to measure business risk of the company.

c) It is directly related to break-even point.

d) It is related to selling price and variable cost.

e) It is concerned with investment decision.

Uses of Operating Leverage

a)      Operating leverage is one of the techniques to measure the impact of changes in sales which lead for change in the profits of the company.

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

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

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

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

f)       Operating leverage describes the overall position of the fixed operating cost.

2) Financial Leverage: 

A Leverage activity with financing activities is called financial leverage. Financial leverage represents the relationship between the company’s earnings before interest and taxes (EBIT) or operating profit and the earning available to equity shareholders. Financial leverage is defined as “the ability of a firm to use fixed financial charges to magnify the effects of changes in EBIT on the earnings per share”. It involves the use of funds obtained at a fixed cost in the hope of increasing the return to the shareholders. Financial leverage can be calculated with the help of the following formula:

FL = OP/PBT

Where,

FL = Financial leverage

OP = Operating profit (EBIT)

PBT = Profit before tax.

Degree of Financial Leverage: Degree of financial leverage may be defined as the percentage change in taxable profit as a result of percentage change in earnings before interest and tax (EBIT). This can be calculated by the following formula:  DFL= Percentage change in taxable Income / Percentage change in EBIT 

How financial leverage magnify shareholder’s earning

Financial leverage is also known as Trading on Equity. Trading on Equity refers to the practice of using borrowed funds, carrying a fixed charge, to obtain a higher return to the Equity Shareholders. With a larger proportion of the debt in the financial structure, the earnings, available to the owners would increase more than the proportionately with an increase in the operating profits of the firm.  This is because the debt carries a fixed rate of return and if the firm is able to earn, on the borrowed funds, a rate higher than the fixed charges on loans, the benefit will go the shareholders. This is referred to as “Trading on Equity”

The concept of trading on equity is the financial process of using debt to produce gain for the residual owners or the equity shareholders. The term owes its name also to the fact that the equity supplied by the owners, when the amount of borrowing is relatively large in relation to capital stock, a company is said to be trading on equity, but where borrowing is comparatively small in relation to capital stock, the company is said to be trading on thick equity. Capital gearing ratio can be used to judge as to whether the company is trading on thin or thick equity.

Impact of Financial leverage on EPS: The EPS is affected by the degree of financial leverage. If the profitability of the concern in increasing then fixed cost funds will help in increasing the availability of profits for equity shareholders. Therefore, financial leverage is important for profit planning. The level of sales and resultant profitability is helpful in profit planning. An important tool of profit planning is break-even analysis. The concept of break-even analysis is used to understand financial leverage. So, financial leverage is very important for profit planning.

Features of financial leverage

a) It is related to the liabilities side of balance sheet.

b) It is calculated to measure financial risk of the company.

c) It is concerned with financing decision i.e., capital structure decision.

d) It shows the effect of changes in capital structure on earning per share.

e) A high leverage company means high financial risk and a low leverage company means low financial risk.

Effect of Financial Leverage on Capital Structure/ Relationship between leverage and capital structure

Leverage can be defined as the amount of debt a firm uses to finance its assets. Leverage refers to debt that is taken to acquire long term assets which are necessary to produce goods and services. Common types of source of funds to acquire fixed assets include debt such as bank loan, debentures and bonds issued by the company and these sources are part of capital structure. There are two types of leverage that namely operating and financial leverage that have a connection to a company’s balance sheet as the items provide capital for repaying bonds or debt. Operating leverage is basically sales revenue less cost of goods sold and less operating expenses, with the result being earnings before interest and taxes (EBIT). Financial leverage is EBIT less interest expenses, taxes, and preference dividend, which result in earnings available for equity share holders, or earnings per share. A high leveraged company means a company whose debt is more than its equity which results in higher financial risk and a low leveraged company means a company whose equity is more than its debt which represents less financial risk.

The term capital structure refers to the relationship between the various long terms sources of financing such as debt and shares. In capital structure, a company most likely prefers to avoid the use of bonds and other debt because high ratio of debt in capital structure increases the financial risk of the company. Equity shares and preference shares more attractive than debt because these are unsecured and there in no compulsory payment of dividends. The use of debt and preference shares capital along with equity shares is called financial leverage. Leverage and capital structure are closely related to each other. Both affects the operating results and financial position of a company. The relation between leverage and capital structure is that companies use a mix of debt and equity to finance its operations. A high ratio of debt in capital structure of a company results in higher amount of interest payment which increases financial leverage and reduces EPS. On the other hand, a low ratio of debt in capital structure of a company reduces financial leverage and increases EPS. Financial leverage is very good for the company who is growing or managing good profits, but in case of economic crises or adverse situation of company this fixed expense make situation more adverse. From the above discussion, we can say that leverage and capital structure are closely related to each other.

Impact of financial leverage on capital structure: The use of long term fixed interest bearing debt and preference share capital along with equity share capital is called financial leverage or trading on equity. The use of long-term debt increases, magnifies the earnings per share if the firm yields a return higher than the cost of debt. The earnings per share also increase with the use of preference share capital but due to the fact that interest is allowed to be deducted while computing tax, the leverage impact of debt is much more. However, leverage can operate adversely also if the rate of interest on long-term loan is more than the expected rate of earnings of the firm. Therefore, it needs caution to plan the capital structure of a firm.

Factors affecting financial leverage: (VVVI Section)

Financial leverage is PBIT/ PBT. Therefore as interest increases, financial leverage will increase.  Interest, in turn, being the cost of borrowed funds, will increase with increase in the proportion of debt used for financing assets. That is why, the ratio of borrowings to assets is also called financial leverage. The higher the degree of financial leverage of a firm, the greater is the sensitivity of its profits before tax to changes in PBIT.

The combined leverage factor which is the product of operating leverage and financial leverage determines the overall sensitivity of profits before tax to change in sales. As income taxes are calculated as a percentage of profit before tax, the net profit will normally be proportionate to the profit before tax. Therefore, fluctuations in profit before tax will bring about corresponding fluctuations in net profits which in turn will bring about fluctuations in earnings per share (EPS) as EPS equals net profit divided by the number of equity shares. Therefore, the combined leverage factor influences the extent to which net profits and EPS will fluctuate for a given fluctuation in sales.

It is important to remember that additional benefits will accrue only when the return on assets is higher than the cost of borrowings. If however, the cost of borrowings is higher than the return on assets; the return on net worth will be even less than the return on assets.

Uses of Financial Leverage

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

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

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

d)      Financial leverage is one of the important devices which are used to measure the fixed cost proportion with the total capital of the company.

e)      If the firm acquires fixed cost funds at a higher cost, then the earnings from those assets, the earning per share and return on equity capital will decrease.

3) 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. Combined leverage is also called as composite leverage or total leverage. Combined leverage expresses the relationship between the revenue in the account of sales and the taxable income. Combined leverage can be calculated with the help of the following formulas:

CL = OL × FL or CL =C / PBT

Where,

CL = Combined Leverage

OL = Operating Leverage

FL = Financial Leverage

C = Contribution

PBT= Profit Before Tax

Degree of Combined Leverage: The percentage change in a firm’s earning per share (EPS) results from one percent change in sales. This is also equal to the firm’s degree of operating leverage (DOL) times its degree of financial leverage (DFL) at a particular level of sales. Degree of contributed coverage = Percentage change in EPS / Percentage change in sales

Difference between Operating Leverage and Financial Leverage

1)      Operating Leverage results from the existence of fixed operating expenses in the firm’s income stream whereas Financial Leverage results from the presence of fixed financial charges in the firm’s income stream.

2)      Operating Leverage is determined by the relationship between a firm’s sales revenues and its earnings before interest and taxes (EBIT). Financial Leverage is determined by the relationship between a firm’s earnings before interest and tax and after subtracting the interest component.

3)      Operating Leverage = Contribution/EBIT and Financial Leverage = EBIT/EBT

4)      Operational Leverage relates to the Assets side of the Balance Sheet, whereas Financial Leverage relates to the Liability side of the Balance Sheet.

5)      Operational Leverage affects profit before interest and tax, whereas Financial Leverage affects profit after interest and tax.

6)      Operational Leverage involves operating risk of being unable to cover fixed operating cost, whereas Financial Leverage involves financial risk of being unable to cover fixed financial cost.

7)      Operational Leverage is concerned with investment decisions, whereas Financial Leverage is concerned with financing decisions.

8)      Operating Leverage is described as a first stage leverage, whereas Financial Leverage is described as a second stage leverage.