Leverage and its Types

Leverage is a practice which can help a business drive up its gains / losses. In business language, if a firm has fixed expenses in P/L account or debt in capital structure, the firm is said to be levered. Nowadays, almost no business is away from it but very few have struck a balance.

In finance, leverage is very closely related to fixed expenses. We can safely state that by the introduction of expenses which are fixed in nature, we are leveraging a firm. By fixed expenses, we refer to the expenses, the amount of which remains unchanged irrespective of the activity of the business. For example, an amount of investment made in fixed assets or interest paid on loans does not change with a normal change in a number of sales. Neither they decrease with a decrease in sales and nor they increase with an increase in sales.

Types of Leverage

There is a different basis for classifying business expenses. For our convenience, let us classify fixed expenses into operating fixed expenses such as depreciation on fixed expenses, salaries etc, and financial fixed expenses such as interest and dividend on preference shares. Similar to them, leverages are also of two types – financial and operating.

Financial Leverage (FL)

It is a leverage created with the help of debt component in the capital structure of a company. Higher the debt, higher would be the FL because with higher debt comes the higher amount of interest that needs to be paid. It Leverage and Types of Leveragescan be both good and bad for a business depending on the situation. If a firm is able to generate a higher return on investment (ROI) than the interest rate it is paying, leverage will have its positive effect shareholder’s return. The darker side is that if the said situation is opposite, higher leverage can take a business to a worst situation like bankruptcy.

Operating Leverage (OL)

Just like the financial, it is a result of operating fixed expenses. Higher the fixed expense, higher is the OL. Like the FL had an impact on the shareholder’s return or say earnings per share, OL directly impacts the operating profits (Profits before Interest and Taxes (PBIT)). Under good economic conditions, an increase of 1% in sales will have more than 1% change in operating profits.

So, you need to be very careful in adding any of the leverages to your business viz. financial or operating as it can also work as a double edged sword.

Advantages and Disadvantages of Leverage

In totality, it has its advantages under good economic situations and at the same time, it is not free from disadvantages.

Advantages of Higher Leverage

Take OL, the operating profits can see a sharp increase with a small change in sales as most parts of the expenses are stagnant and cannot further increase with sales.

Likewise, if we consider FL, the earnings share of each shareholder will increase significantly with an increase in operating profits. Here, higher the degree of leverage, higher will be the percentage increase in operating profits and earnings per share.

Disadvantages of Higher Leverage

Leverage inherits the risk of bankruptcy along with it. In the case of operating leverage, fixed expenses extend the break-even point for a business. Break even means the minimum activity (sales) required for achieving no loss / no profit situation. Financial leverage increases the minimum requirement of operating profits to meet with the expense of interest. In any case, if the required activity level not achieved, bankruptcy or cash losses become certain.

Looking at the pros and cons, it seems that a balance is required between the rewards and risks. The degree of leverage should not be too high which invites the bankruptcy and on the contrary, it should not be too low that we lose out on the benefits and the viability of a business itself comes under question.

Last updated on : July 12th, 2017
What’s your view on this? Share it in comments below.

Leave a Reply

Capital Structure Theory – Net Operating Income …
  • Modigliani and Miller (MM) Approach
    Capital Structure Theory – Modigliani and Miller …
  • Net Income Approach
    Capital Structure Theory – Net Income Approach
  • Net Income (NI) vs. Net Operating Income (NOI) Approach
    Net Income (NI) vs. Net Operating Income …
  • Factors affecting Capital Structure Decisions
    Factors affecting Capital Structure Decisions
  • Subscribe to Blog via Email

    Enter your email address to subscribe to this blog and receive notifications of new posts by email.

    Join 122 other subscribers

    Recent Posts

    Find us on Facebook

    Related pages

    asset liabilities ratiowhat is overdraft limitinstalment salesconvertible bond conversionunsecured debenturenon redeemable debenturesfeatures of zero based budgetingcalculate days receivableoperating capital loansexample of irr calculationdcf valuation examplefixed assets coverage ratio formulaoperating cycle in financebills payable and bills receivable pdfeps calculationsgross profit ratio interpretationsbi bank guaranteetypes of company sharesdividend payout ratio examplecost of debt in waccleasing meaning in hindibill discountingsecured debenturesnegative covenants loan agreementearnings per share computationdisadvantages of debt financingwhat is owner's equitywhat is profitability ratiodefine standby letter of creditcalculating wacc examplemeaning of surplus in hindidebt asset ratio analysishow to calculate capital requirementnvp financehow to analyse financial statements using ratio analysishow to find asset turnover ratiosalvage value in npvratio of liabilities to stockholders equityreceiveables turnoverdefine debt service coverage ratiowacc problemdef liabilityinventory turnover definitioncapital vs operating leaseswhat does a negative irr meansecured debenturemeaning of bookkeepingdupont financial statementsrumus cost of debttypes of loan covenantsleverage ratio analysis interpretationmodigliani miller proposition 1budgeting defstable dividend policy definitionthe contribution margin per unit is equal to theratio analysis comparison between two companiesdefinition bookkeepingreverse merger investopedianet working assets to sales ratiomulti stage dividend discount modelwhat is the meaning of hedging in financehow to improve solvency ratioredeemable debenturemeaning of investment avenuesdefine coupon bondadr and gdr differenceadvantages and disadvantages of weighted average methodleverages meaningaccounts receivable turnover formularoi rocegaap advantagesroa examplefixed versus variable costsforex economicslimitation of payback periodwacc assumptionsbeneficiary meaning in banking