The term leverage refers to the relationship between two inter-related variables. It is the technique used by business firms to measure risk and return relationship of different alternative capital structures.
In financial analysis, it represents the influence that one financial variable has over some other related financial variables. These financial variables may be sales, cost, EBIT, EPS, etc.
In Leverage analysis, the emphasis is on the measurement of the relationship between the two variables rather than measuring the variables.
DIFFERENT TYPES OF LEVERAGES
# OPERATING LEVERAGE
It is defined as the firm’s ability to use fixed operating cost to magnify the effect of changes in sales on its Earnings Before Interest and Tax(EBIT). The relation between Contribution and EBIT is called as Operating Leverage. It may be defined as the rate of changes in EBIT due to change in the rate of sales.
The firm with high fixed operating costs has the higher degree of operating leverage. The Higher level of risk is attached to a higher degree of leverage. High operating leverage is good when sales are increasing and bad when they are falling.
CHARACTERISTICS OF OPERATING LEVERAGE
Related to fixed cost: If there are fixed costs in firms, there will be operating leverage.
Highest OL near B.E.P: There is a direct relationship between operating profit and Break Even Point (BEP). The Degree of operating leverage is highest near B.E.P.
# FINANCIAL LEVERAGE
It is defined as the ability of the firm to use fixed financial charges to magnify the effect of changes in EBIT on the Earnings Per Share (EPS). It measures the relationship between EBIT and EPS.
CHARACTERISTICS OF FINANCIAL LEVERAGE
Concerned with liabilities side of the balance sheet: It is related to the liabilities side of the balance sheet, where different types of sources of capital are shown.
Related to Fixed cost of capital: If there is no fixed cost of capital, then there will be no financial leverage.
Financial Risk: The financial risk of the firm increases with the presence of financial leverage.
# COMBINED LEVERAGE
Combined Leverage measures the total risk of the firm both operating risk and financial risk. it measures the relationship between sales and EPS i.e., Combined Leverage express the relationship between the revenue in the account of sales and taxable income.