Types of Leverage
In finance, leverage, sometimes referred to as gearing in the United Kingdom, is a commonly known term for any technique to multiply gains and losses. Common ways to attain leverage are buying fixed asset, employing derivatives and borrowing money. Substantial instances are:
a) A public corporation may purchase its equity by borrowing money. The more it takes over, the less equity capital it needs, To a very great extent any profits or losses are dealt among a smaller base and to a proportionate degree larger as a result.
b) A business entity can purchase its revenue by buying fixed assets. This will increase the proportion of fixed, as opposed to variable, costs, meaning that a alter in revenue will outcome in a larger change in operating income.
Hedge funds often leverage their assets by employing derivatives. A fund might acquire any gains or losses on $40 million worth of crude oil by posting $12million of cash as margin.
Leverage is scientific tool in the hand of finance manager . Finance manager employs this tool for making effective financial structure of company . Financial structure is just combination of equity and debt and with help of leverage. The finance manager acquires fund with effective ratio of debt and equity.
In general, leverage establish a relationship amongst two inter-associated variables. These variables may be output, cost, profit and sale. Finance manager computes these leverage by apply formula and then employs them for taking decision in favor of company's shareholder . primary objective of leverage testing is maximize the earning of shareholder and bring down the risk of company.
There are 3 type of leverages, which are as following:
i) Operating leverage:
Operating leverage is % alteration in earning ahead of interest and tax divided by % alteration in sale . If company is charging fixed cost, the operating leverage specifies the EBIT will higher than sale as due to increasing sale of constant cost per unit will diminish and it will increase EBIT higher than sale .
Formula
Operating Leverage = % change in EBIT / % change in Sale
This leverage is very assistance for finance manager since, if operating leverage is more than or suppose it is two then it means if sale will increase 50% then earning will increase 100% . At this time , finance manager can acquire more loan for increasing the earning of shareholders .
ii) Financial leverage:
It is second type of leverage referred as Financial leverage, also known as trading on equity . If any finance manager of a company knows that company's return on investment is more than borrowing obligation or interest on loan. At this time , if company calls for more money , then finance manager acquires its loan and bought the asset from same loan . So, any technique in which any asset is purchased with loan and attempting to increase Earnings Per Share , then this is known as financial leverage.
Formula for computing financial leverage:
= % change in Earning per share / % change in earning before interest and tax
= % change in Earnings Per Share / % change in EBIT
This formula explains the relationship amongst % change in Earnings Per Share and % change in EBIT and later on following the in depth analysis of this financial leverage , finance manager decides to acquire appropriate loan for buying assets .
iii) Combined leverage :
It is the product of financial and operating leverage.
Combined leverage = Operating leverage X financial leverage
= % change in EBIT / % change in sale X % change in Earnings Per Share / % change in EBIT
→ Higher operating leverage and higher financial leverage combination brings higher risk for business .
→ Good combination is that in which lower operating leverage with high financial leverage
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