Leverage¶
Leverage, in a business context, refers to the use of various financial instruments or borrowed capital (like debt) to increase a company's potential return on investment. The primary idea behind leverage is to use external funds to amplify potential gains, but it's important to note that it can also magnify losses.
Types of Leverages¶
Operating Leverage¶
Definition: Operating leverage measures the proportion of fixed costs in a company's overall cost structure. High operating leverage means that a company has a larger proportion of fixed costs compared to variable costs.
Impact: When sales increase, companies with high operating leverage experience a more significant increase in profits because their fixed costs remain constant while revenue grows. Conversely, during low sales, the high fixed costs can lead to larger losses.
Formula:
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Operating Leverage = \(\frac{Contribution}{EBIT}\)
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Degree of Operating Leverage = \(\frac{\% Change in EBIT}{\% Change in Sales}\)
where EBIT = Earnings Before Interest and Taxes. You can find these in the Income Statement of a company.
Financial Leverage¶
Definition: Financial leverage refers to the use of debt to acquire additional assets. It's based on the idea that borrowed money can increase returns to shareholders if the return from the investment is higher than the cost of debt.
Impact: Financial leverage can lead to higher profits on successful investments. However, if the return on investment is less than the interest on the debt, it can significantly increase the risk of loss.
Formula:
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Degree of Financial Leverage = \(\frac{EBIT}{Earnings Before Taxes(EBT)}\)
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Financial Leverage = \(\frac{\% Change in EPS}{\% Change in EBIT}\)
Combined Leverage¶
Definition: Combined leverage takes into account both operating and financial leverage. It provides an overall picture of how a change in sales level will affect a company's earnings.
Impact: It is used to understand the combined effect of using both operational and financial leverage on the company's earnings.
Formula:
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Combined Leverage = Operating Leverage * Financial Leverage
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Combined Leverage = \(\frac{Contribution}{EBIT}\) * \(\frac{EBIT}{EBT}\)
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Combined Leverage = \(\frac{Contribution}{EBT}\)
where EBIT = Earnings Before Interest and Taxes, EBT = Earnings Before Taxes. You can find these in the Income Statement of a company.
| Description | Amount |
|---|---|
| Sales | XXX |
| Less: Variable Costs | (XXX) |
| Contribution | XXX |
| Less: Fixed Costs | (XXX) |
| Operating Profit (EBIT) | XXX |
| Less: Interest | (XXX) |
| Earnings Before Taxes (EBT) | XXX |
| Particular | Formula |
|---|---|
| Operating Leverage | \(\frac{Contribution}{EBIT}\) |
| Financial Leverage | \(\frac{EBIT}{EBT}\) |
| Combined Leverage | \(\frac{Contribution}{EBT}\) |
In summary, understanding these types of leverage is crucial for businesses as they provide insights into the risk and return profile of the company. High leverage might mean higher returns, but it also comes with increased risk.