Leverage refers to the ability of firm to employ long-term funds having a fixed cost to enhance return to the owners. Leverage analysis is the employment of fixed assets or funds for which company has to pay fixed costs i.e., fixed operating cost and fixed financial charges and study their impact on earnings available to the equity shareholders. These fixed costs have to be incurred regardless of level of activities or profit. Different types of Leverages: –
Operating Leverage: -Features of Operating Leverage are as follows:-
- Operating leverage is the firm’s ability to use fixed operating costs to magnify the effect of changes in sales on its operating income. It is calculated by dividing percentage change in EBIT by percentage change in sales.
- It is related to the presence of fixed operating cost in the overall cost structure of the firm.
- Degree of operating leverage can be calculated by dividing contribution by EBIT. It depends upon the amount of fixed cost, level of sales and profit-volume ratio.
- High operating leverage indicates presence of high fixed operating costs.
- DOL measures the business risk in which firm is operating and it helps in investment decision
Financial Leverage: -Features of Financial Leverage are as follows:-
- Financial leverage is the ability of the firm to use fixed financial charges to magnify the effect of changes in EBIT on the EPS. It is calculated by dividing percentage change in EPS by percentage change in EBIT.
- It is related to presence of fixed financial charges i.e. presence of fixed charge securities in overall capitalisation of the firm.
- Degree of financial leverage can be calculated by dividing EBIT by EBT.
- High financial leverage indicates the presence of higher finance charges or employment of more debts fund in the capitalization of the firm
- DFL is index of financial risk a firm is facing and helps in financial decisions
