Financial Leverages – operating, Financial & Composite (Management)

In this topic, we will cover Financial Leverages – operating, Financial & Composite leverage (Management) which is an important technique to measure the effectiveness of capital structure owned by any business organization and useful for UGC NET, Commerce, and Management students. Keep reading our latest articles subscribe to our blog from below:

Financial leverages- Financial Management

Leverage:

The term leverage refers to an increased means of accomplishing some purpose. leverage is used to lifting heavy objects, which may not be otherwise possible. From the financial point of view, leverage refers to furnish the ability to use fixed cost assets or funds to increase the return to its shareholders.

 Financial Leverages, in business terminology, really just means debt. It’s the borrowing of funds to finance the purchase of inventory, equipment, and other company assets. Business owners can use either debt or equity to finance or buy company assets. Using debt increases the company’s risk of bankruptcy but can also increase the company’s profits and returns; specifically its return on equity. If debt financing is used rather than equity financing, the owner’s equity is not diluted by issuing more shares of stock. Borrowing funds in order to expand or invest is referred to as leverage because the goal is to amplify the loan into greater value for the firm or investors.

There are three types of Financial leverages

1. Operating leverage
2. Financial leverage
3. Composite leverage  

1.Operating leverage

 The breakeven analysis states that there are essentially two types of costs in a company’s structure: fixed costs and variable costs. Operating leverage refers to the percentage of fixed costs that a company has. Stated another way, operating leverage is the ratio of fixed costs to variable costs; if a business firm has more fixed costs as compared to variable costs, then the firm is said to have high operating leverage.

A capital intensive firm is one that uses fixed costs, for example, those within the automotive industry, as they need a huge amount of equipment to manufacture and service their products. When the economy slows down and fewer people are buying new cars, the auto companies still have to pay their fixed costs, such as overhead on factories, depreciation on equipment, and other fixed costs associated with a capital intensive business.

If a firm has high operating leverage, a small change in sales volume results in a large change in return on invested capital (ROIC). In other words, firms with high operating leverage are very sensitive to changes in sales, and this is quickly reflected by their bottom line.

OL can be calculated with the help of the following formula:

        Ol=C/OP

Where 0l =operating leverage

            C =contribution

          Op= operating ratio

Degree of operating leverage can be calculated as:

The degree of operating leverage can be defined as a % change in the profits resulting from a % change in sales.

DOL=% change in profits / % change in sales

2. FINANCIAL LEVERAGE

Financial leverage refers to the amount of debt in the accounts of the firm. financial leverage may be defined as the ability of a firm to use fixed financial charges to magnify the effects of changes in EBIT on the earning per share. It involves the use of funds obtained at a fixed cost in the hope of increasing the return to the shareholders. “ The use of long term fixed interest besring debt and preference share capital along with equity share capital is called the financial leverage or trading on equity.”

Financial leverage may be favorable when the company earns more on the assets purchased with the funds, then the fixed cost of their use. And financial leverage may be unfavorable when the company does not earn as much as the funds cost. Hence it is called negative financial leverage.

Financial leverage can be calculated as:

                          Fl=OP / PBT

Where,

Fl= financial leverage

Op=operating profit(EBIT)

PBT= profit before taxes

Degree of financial leverage

The degree of financial leverage may be defined as the % change in taxable profits as a result of % change in earnings before interest and tax.

DFL= % change in taxable income / % change in EBIT

3. Combined leverage

When the company uses both financial and operating leverage to the magnification of any change in sales into a larger relative change in earning per share. Combined leverage also called composite leverage or total leverage.

operating leverage notes returns from fixed assets and financial leverage note the returns from debt financing, combined leverage is the sum of both.

Combined Leverages can be calculated as:

 Cl=OL x FL

Cl= c / op x op/PBT=C/PBT

Where CL=Combined leverage

OL= operating leverage

FL= financial leverage

C= contribution

Op= operating profit(EBIT)

PBT= profit before tax

Degree of combined leverage

The % change in a firm earning per share results from % change in sales.

DCL=% change in EPS/ % change in sales