leverage and its types
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Leverage and its types
>> June 11, 2009
Leverage is very scientific tool in the hand of finance manager . Finance manager uses this tool
for making effective financial structure of company . Financial structure is just mix of debt andequity and with help of leverage , finance manager gets fund with effective ratio of debt and
equity .
In simple word leverage is power and relationship between two interrelated variables . These
variables may be output , sale , cost and profit . Finance manager calculates these leverage by
apply formula and then uses them for taking decision in favour of company's shareholder . Mainaim of leverage testing is maximize the earning of shareholder and reduce the risk of company.
Type of leverage :-
Company's finance manager tests three type leverage :-
1. Operating leverage is % change in earning before interest and tax divided by % change in
sale . If company is charging fixed cost , the operating leverage tells the EBIT will greater thansale because due to increasing sale of fixed cost per unit will decrease and it will increase EBIT
higher than sale .
Formula
Operating Leverage = % change in EBIT / % change in Sale
This leverage is very helpful for finance manager because , if operating leverage is more than or suppose it is two then it means if sale will increase 100% then earning will increase 200% . At
this time , finance manager can get more loan for increasing the earning of shareholders .
2. Financial leverage
It is second type of leverage . Financial leverage is known as trading on equity . If any
company's finance manager knows that company's return on investment is more than interest on
loan or borrowing obligation . At this time , if company needs more money , then financemanager gets its loan and bought the asset from same loan . So, any technique in which any asset
is purchased with loan and trying to increase EPS , then this is called financial leverage .
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Formula for calculating financial leverage
= % change in Earning per share / % change in earning before interest and tax
= % change in EPS / % change in EBIT
This formula explains the relationship between % change in EPS and % change in EBIT and
after deep study of this financial leverage , finance manager decides to get appropriate loan for buying assets .
3. Combined leverage
It is the product of operating leverage and financial leverage .
Combined leverage = Operating leverage X financial leverage
= % change in EBIT / % change in sale X % change in EPS / % change in EBIT
→ High operating leverage and high financial leverage combination is high risky for business .→ Good combination is that in which lower operating leverage with high financial leverage .
Financial Leverage Simplified
>> March 7, 2011
Financial leverage is hugely utilized in corporate finance. But today, we are simplifying it by providing example of a sole trade. We know that in sole trade all capital is of one person and his
aim is to maximize it. With financial leverage he can do it.
Financial leverage is tool to use own capital with debt for doing business. Following is theexample which will simplify this finance term.
Mr. A has own capital of Rs. 5,00,000 and he bought a machine with his Rs. 5,00,000. Mr. A is
not using financial leverage because he is using his own money for trading.
Mr. B has own capital of Rs. 5,00,000 and he took the loan of Rs. 10,00,000 @ 5% fixed
interest. Now, he has Rs. 1500000 and he bought top quality machine with this Rs. 15,00,000.
If the machines owned by Mr A and Mr. B increase in value by 10% and are then sold, Mr.
A will have a Rs. 50,000 profit on his own capital Rs. 500,000, a 10% return. Mr. A ’s land will
sell for Rs. 16,50,000 and will result in a gain of Rs. 150,000.
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Now if we calculate the Mr. B's return on his own capital, it will be very high.
Mr. B's Return on his own capital = Rs. 150000/ Rs. 500000 X 100 = 30%
Suppose, if B has to pay interest of 5% on debt, then he will gain net = Rs. 150000 - 50,000 =1,00,000
which will be the 20% of his own capital. Mr. A who is not using financial leverage, is gaining just 10% return.
Suppose if machine's value will increase by 20% and sell, then Mr. B's Return on his own
capital after deducting 5% fixed interest, will be = Rs. 300,000 profit from sale of machine - Rs.50000 interest
= Rs. 250000
Or = 250000/500000 X 100 = 50% which is 30% more than Mr. A's profit.
It means when assets inflate in value financial leverage works well. But when assets decline invalue the use of leverage works against you.
What is ROE?
Before analysing, leverage effect, we should know what is return on equity? Returnon equity is that rate of return on equity share capital. It is also called shareholderreturn. ROE can be seen with two way. From company point of view, it is return onhis investment which company has to raise at any cost for surviving the businessbut from shareholder point of view, it is dividend. ROE shows the efficiency of
company. If company generated high ROE, it is good for company and itsshareholders. ROE can be changed by changing the leverage. Now we study theeffect of leverage on ROE.
What are Sources of Leverage?
a) Taking Loan
b) Taking fixed asset
c) Taking Hedge fund
Leverage Effect on ROE
If we talk the leverage effect on ROE, it means, we talking operating leverageeffect, financial leverage effect and combined leverage effect on ROE.
1. Operating Leverage Effect : % Change of EBIT is more than % Change inSale
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If % change of earning before interest and tax is more than % change in sale, thisoperating leverage will effect ROE positively because at this level, per unit fixedcost will decrease and small increase in sale will boost EBIT. If EBIT will increase,ROE will also increase. After dividing % Change of EBIT with % changes in sales. Wecan take ratio of it and it indicates, how will change EBIT if changes will be done in
sales. 2:1 of operating leverage means if 100% sales will increase 200% EBIT willincrease. As interest is fixed cost, so with this ROE will increase.
A Situation : High Operating Leverage :
Too high operating leverage is not good, it may be high risky.
B Situation : Low Operating Leverage :
Low operating leverage may be useful when sale market is fluctuating.
2. Operating Leverage Effect : % Change of EBIT is less than % Change in
Sale
Now see also second face when % changes of EBIT is less than % changes in sales,it means 200% sale will increase, 100% EBIT will increase if operating leverage is1:2. This situation is less effective for enhancing ROE.
3. Effect of Financial Leverage on ROE
If we have to check real effect of leverage on ROE, we have to study financialleverage. Financial leverage refers to the use of debt to acquire additional assets.Financial leverage may decrease or increase return on equity in different conditions.
A Situation : High Financial Leverage :
Financial over-leveraging means incurring a huge debt by borrowing funds at alower rate of interest and utilizing the excess funds in high risk investments in orderto maximize returns.B Situation : Low Financial Leverage :
Financial low-leveraging means incurring a low debt by borrowing funds. It mayeffect positively, if decrease the value of bought asset with this low debt.
4. Effect of High Operating leverage and High Financial Leverage
It will increase ROE but it is high risky also.
5. Effect of Low Operating leverage and High Financial Leverage
It is optimum combination for bringing optimum return on equity.
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