- Leverage provides the framework for financing decisions of a
firm. It may be defined as the employment of an asset/source of
funds for which the firm has to pay a fixed cost, or fixed
return.
- Leverage may be (i) Operating, (ii) Financial, or (iii)
Combined
2. OPERATING LEVERAGE
- Leverage associated with asset acquisition/investment
activities is referred to as theoperating leverage.It may be
defined as the ability to use fixed operating costs to magnify the
effect of changes in sales on its operating profits (EBIT). Thus,
operating leverage is determined by the relationship between sales
revenue and EBIT. When proportionate change in EBIT as a result of
change in sales is more than the proportionate change in sales,
operating leverage occurs.
OR 3. OPERATING LEVERAGE-CONTINUED 4. FINANCIAL LEVERAGE
- Financial leverage is the second type of leverage. It is
related to the financing activities of a firm. It results from the
presence of fixed financial charges. Such expenses dont vary with
operating profits (EBIT). They have to be paid regardless of the
amount of EBIT available to pay them. After paying them, the EBIT
belongs to the shareholders. Financial leverage is concerned with
the effect of changes in EBIT on the earning available to the
shareholders (EPS). It may be defined as a ability of a firm to use
fixed financial charges to magnify the effect of changes in EBIT on
EPS.
ie. Earning after interest but before tax. 5. COMBINED
LEVERAGE
- Combined leverage is the product of operating and financial
leverage. It indicates the effect that sales changes will have on
EPS.
Alternatively