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 and equity 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 . Main aim 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 than sale 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 finance manager 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 .

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 the example 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. As land will sell for Rs. 16,50,000 and will result in a gain of Rs. 150,000.

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 in value the use of leverage works against you.
What is ROE? Before analysing, leverage effect, we should know what is return on equity? Return on equity is that rate of return on equity share capital. It is also called shareholder return. ROE can be seen with two way. From company point of view, it is return on his investment which company has to raise at any cost for surviving the business but 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 its shareholders. ROE can be changed by changing the leverage. Now we study the effect 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 leverage effect, financial leverage effect and combined leverage effect on ROE. 1. Operating Leverage Effect : % Change of EBIT is more than % Change in Sale

If % change of earning before interest and tax is more than % change in sale, this operating leverage will effect ROE positively because at this level, per unit fixed cost 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. We can 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 will increase. 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 is 1:2. 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 financial leverage. 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 a lower rate of interest and utilizing the excess funds in high risk investments in order to maximize returns. B Situation : Low Financial Leverage : Financial low-leveraging means incurring a low debt by borrowing funds. It may effect 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.