Leverage is very scientific tool in the hand of finance manager . Finance manager uses this tool for making effective financial structure of company . Financial structure is just mix of debt and equity and with help of leverage , finance manager gets fund with effective ratio of debt and equity .

In simple word leverage is power and relationship between two interrelated variables . These variables may be output , sale , cost and profit . Finance manager calculates these leverage by apply formula and then uses them for taking decision in favour of company's shareholder . Main aim of leverage testing is maximize the earning of shareholder and reduce the risk of company.

Type of leverage :-


Company's finance manager tests three type leverage :-

1. Operating leverage

Operating leverage is % change in earning before interest and tax divided by % 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


This leverage is very helpful for finance manager because , if operating leverage is more than or suppose it is two then it means if sale will increase 100% then earning will increase 200% . At this time , finance manager can get more loan for increasing the earning of shareholders .


2. Financial leverage


It is second type of leverage . Financial leverage is known as trading on equity . If any company's finance manager knows that company's return on investment is more than interest on loan or borrowing obligation . At this time , if company needs more money , then finance manager gets its loan and bought the asset from same loan . 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

This formula explains the relationship between % change in EPS and % change in EBIT and after deep study of this financial leverage , finance manager decides to get appropriate loan for buying assets .


3. Combined leverage


It is the product of operating leverage and financial leverage .

Combined leverage = Operating leverage X financial leverage

= % change in EBIT / % change in sale X % change in EPS / % change in EBIT

→ High operating leverage and high financial leverage combination is high risky for business .
→ Good combination is that in which lower operating leverage with high financial leverage .

Advantages and Disadvantages of Leverage

In totality, leverage has its advantages under good economic situations and at the same time, it is not free from disadvantages.

Advantages of Higher Leverage: Take operating leverage, the operating profits can see a sharp increase with a small change in sales as most part of the expenses are stagnant and cannot further increase with sales.

Likewise, if we consider financial leverage, the earnings share of each shareholder will increase significantly with an increase in operating profits. Here, higher the degree of leverage, higher will be percentage increase in operating profits and earnings per share.

Disadvantages of Higher Leverage: Leverage inherits the risk of bankruptcy along with it. In case of operating leverage, fixed expenses extend the breakeven point for a business. Breakeven means the minimum activity (sales) required for achieving no loss / no profit situation. Financial leverage increases the minimum requirement of operating profits to meet with the expense of interest. In any case, if the required activity level not achieved, bankruptcy or cash losses become certain.

Looking at the pros and cons of leverage, it seems that a balance is required between the rewards and risks associated with leverage. The degree of leverage should not be too high which invites the bankruptcy and on the contrary it should not be too low that we lose out on the benefits and the viability of a business itself comes under question.