Article

Leverage
June 07 , 2012

It is the degree to which an investor or business is utilizing borrowed money. Companies that are highly leveraged may be at risk of bankruptcy if they are unable to make payments on their debt; they may also be unable to find new lenders in the future. Financial leverage is not always bad, however; it can increase the shareholders' return on their investment and often there are tax advantages associated with borrowing.

There are three types of leverages: 1) Operating Leverage 2) Financial Leverage 3) Combined Leverage

  1. Operating leverage is % change in earning before interest and tax for every % change in sale. If company is charging fixed cost, the operating leverage tells the EBIT will greater than sale because due to increasing sale of fixed cost per unit will decrease and it will increase EBIT higher than sale. Formula Operating Leverage = % change in EBIT / % change in Sale 
  2. Financial leverage is the % change in EPS for every % change in EBIT. So, any technique in which any asset is purchased with loan and trying to increase EPS, then this is called financial leverage. Formula for calculating financial leverage = % change in Earning per share / % change in earning before interest and tax = % change in EPS / % change in EBIT. 
  3. Combined leverage is the product of operating leverage and financial leverage. Combined leverage = Operating leverage * financial leverage = (% change in EBIT / % change in sale) * (% change in EPS / % change in EBIT)

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