Leverage Meaning, Types, Features, Uses, 8 Differences | Financial Management & Strategic Management for CA Intermediate PDF Download

Leverage Meaning

Leverage denotes an enhanced capacity to achieve a specific goal. It allows for the lifting of heavy objects that might otherwise be too difficult to manage. From a financial perspective, leverage involves utilizing fixed-cost assets or funds to amplify returns for shareholders.

James Horne describes leverage as the utilization of an asset or fund that incurs a fixed cost or yield.

Leverage Types

Operating Leverage

Operating leverage is linked to investment activities and arises from fixed operating expenses within a company. It signifies the firm's ability to amplify the impact of sales fluctuations on its earnings before interest and taxes (EBIT) using fixed operating costs. Operating leverage comprises fixed and variable costs. A company exhibits high operating leverage when it has substantial fixed costs and minimal variable costs. The degree of operating leverage is influenced by the cost structure. Break-even analysis aids in determining operating leverage, calculated by the formula:
OL = C/OP
Where ,
OL = Operating Leverage
C = Contribution
OP = Operating Profits
Operating leverage degree can be defined as the percentage change in profits due to a percentage change in sales. This measure can be computed using the following formula:
DOL = Percentage change in profits/Percentage change in sales

Features of operating leverage:

• It is related to the assets side of balance sheet.
• It is calculated to measure business risk of the company.
• It is directly related to break-even point.
• It is related to selling price and variable cost.
• It is concerned with investment decision.

Uses of Operating Leverage:

• Operating leverage is a method used to assess how changes in sales impact a company's profits.
• Changes in sales result in corresponding changes in profit.
• Operating leverage aids in identifying the proportions of fixed and variable costs.
• Operating leverage gauges the connection between a company's sales and revenue over a specific timeframe.
• Operating leverage provides insight into the amount of fixed costs allocated to operating expenses in business operations.
• Operating leverage gives an overview of the fixed operating costs' significance.

Financial Leverage

Financial leverage pertains to activities involving financing and represents the connection between a company's earnings before interest and taxes (EBIT) or operating profit and the earnings available to equity shareholders. It's defined as "the capacity of a firm to amplify the impacts of changes in EBIT on earnings per share by utilizing fixed financial charges." This strategy involves leveraging funds acquired at a fixed cost to potentially enhance shareholder returns. The formula to calculate financial leverage is as follows:
FL = OP/PBT
Where,
FL = Financial leverage
OP = Operating profit (EBIT)
PBT = Profit before tax.

Financial leverage degree is the percentage change in taxable profit due to a percentage change in earnings before interest and tax (EBIT). This can be computed using the following formula: DFL = Percentage change in taxable income / Percentage change in EBIT.

How financial leverage magnify shareholder’s earning

• Financial leverage, also known as Trading on Equity, involves using borrowed funds with fixed charges to generate higher returns for equity shareholders. When a company has a higher proportion of debt in its financial structure, the earnings available to owners can increase more than proportionately with a rise in operating profits. This occurs because debt carries a fixed rate of return, and if the firm earns a rate higher than the fixed charges on loans, shareholders benefit—a concept referred to as "Trading on Equity."
• The idea of trading on equity is about using debt to benefit equity shareholders. It's named as such because when borrowing is substantial relative to the capital stock, a company is said to be trading on equity; when borrowing is minimal compared to capital stock, it's trading on thick equity. The capital gearing ratio helps determine if a company is trading on thin or thick equity.
• Financial leverage impacts earnings per share (EPS) by influencing profitability. As profitability rises, fixed-cost funds contribute to increased profits for equity shareholders. Therefore, financial leverage plays a crucial role in profit planning, where sales levels and resulting profitability are key factors. Break-even analysis, an important tool in profit planning, is used to understand financial leverage, highlighting its significance in profit planning processes.

Features of financial leverage:

• It is related to the liabilities side of balance sheet.
• It is calculated to measure financial risk of the company.
• It is concerned with financing decision i.e., capital structure decision.
• It shows the effect of changes in capital structure on earning per share.
• 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 refers to the strategic utilization of debt to finance a firm's assets, particularly long-term assets essential for production. This debt is typically sourced from avenues such as bank loans, debentures, and company-issued bonds, forming a crucial part of the company's capital structure. There are two primary forms of leverage: operating and financial. Operating leverage is reflected in the company's sales revenue minus costs and operating expenses, resulting in earnings before interest and taxes (EBIT). Financial leverage, on the other hand, involves EBIT minus interest expenses, taxes, and preference dividends, culminating in earnings available for equity shareholders or earnings per share (EPS). A highly leveraged company carries more debt than equity, leading to increased financial risk, while a low-leverage company has more equity than debt, indicating lower financial risk.
• Capital structure, meanwhile, encompasses the composition of a company's long-term financing sources, such as debt and equity. Companies often aim to minimize reliance on bonds and debt due to the heightened financial risk associated with a high debt-to-equity ratio. Equity and preference shares are often preferred over debt due to their unsecured nature and the absence of mandatory dividend payments. The combination of debt, preference shares, and equity shares is termed financial leverage, closely intertwined with capital structure. Both leverage and capital structure significantly impact a company's operational performance and financial standing, with companies striking a balance between debt and equity to support their operations. Higher debt in the capital structure leads to increased interest payments, elevating financial leverage and reducing EPS, while lower debt results in decreased financial leverage and higher EPS. Financial leverage can be advantageous during growth periods or when a company is generating substantial profits, yet it can exacerbate challenges during economic downturns or adverse company conditions due to fixed expenses. This interplay underscores the intrinsic connection between leverage and capital structure.
• The impact of financial leverage on capital structure is evident in how the use of long-term fixed-interest debt and preference share capital, combined with equity share capital, creates a mechanism for trading on equity. Utilizing long-term debt can boost EPS if the firm's returns surpass the cost of debt. While preference share capital also contributes to EPS growth, the impact of debt leverage is typically more significant due to tax deductibility. However, excessive interest rates on long-term loans relative to expected earnings can reverse these benefits, necessitating careful capital structure planning to mitigate risks.

Factors affecting financial leverage

• Financial leverage is calculated as the ratio of profit before interest and taxes (PBIT) to profit before tax (PBT). Consequently, an increase in interest leads to a rise in financial leverage. Since interest represents the expense incurred from borrowed funds, a higher proportion of debt in asset financing escalates interest costs. This association is why the ratio of debt to assets is termed financial leverage. A firm with higher financial leverage exhibits greater sensitivity of its pre-tax profits to changes in PBIT.
• The combined leverage factor, derived from both operating and financial leverage, determines the overall sensitivity of pre-tax profits to sales variations. Given that income taxes are a percentage of pre-tax profit, net profit usually mirrors pre-tax profit. Consequently, fluctuations in pre-tax profit translate to corresponding changes in net profits, impacting earnings per share (EPS), which equals net profit divided by equity shares. Therefore, the combined leverage factor dictates how much net profits and EPS fluctuate with sales shifts.
• It's crucial to note that additional benefits arise only when asset returns exceed borrowing costs. Conversely, if borrowing costs surpass asset returns, the return on net worth falls below the return on assets.

Uses of Financial Leverage

• Financial leverage facilitates the analysis of the connection between EBIT and EPS.
• Financial leverage quantifies the rate of change in taxable income relative to the rate of change in EBIT.
• Financial leverage aids in making informed financial decisions regarding the company's capital structure.
• Financial leverage serves as a vital tool for assessing the proportion of fixed costs in relation to the company's total capital.
• When a firm obtains fixed-cost funding at a higher rate, it leads to decreased earnings from those assets, lower earnings per share, and reduced return on equity capital.

Combined leverage

When a company employs both financial and operating leverage, it amplifies any sales change into a more significant relative change in earnings per share. Combined leverage, also known as composite leverage or total leverage, illustrates the correlation between sales revenue and taxable income. It can be computed using 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 (DCL): The degree to which a company's earnings per share (EPS) fluctuate in response to a one percent change in sales. This is equivalent to the product of the firm's degree of operating leverage (DOL) and degree of financial leverage (DFL) at a specific sales level. The degree of contributed coverage is calculated as the percentage change in EPS divided by the percentage change in sales.

Difference between Operating Leverage and Financial Leverage

• Operating Leverage stems from fixed operating expenses within a company's income stream, while Financial Leverage arises from fixed financial charges within the income stream.
• Operating Leverage is determined by the correlation between a firm's sales revenues and its earnings before interest and taxes (EBIT), whereas Financial Leverage is determined by the relationship between a firm's earnings before interest and taxes (EBT) and its earnings after subtracting the interest component.
• The formula for Operating Leverage is Contribution divided by EBIT, and for Financial Leverage, it is EBIT divided by EBT.
• Operational Leverage pertains to the Assets side of the Balance Sheet, while Financial Leverage pertains to the Liability side.
• Operational Leverage influences profit before interest and taxes, while Financial Leverage impacts profit after interest and taxes.
• Operational Leverage encompasses the operating risk of failing to cover fixed operating costs, whereas Financial Leverage encompasses the financial risk of failing to cover fixed financial costs.
• Operational Leverage pertains to investment decisions, while Financial Leverage pertains to financing decisions.
• Operating Leverage is considered a primary stage of leverage, while Financial Leverage is considered a subsequent stage of leverage.