Leverages are of three types:
Financial Leverage: Financial leverage is a leverage created with the help of debt component in the capital structure of a company. Higher the debt, higher would be the financial leverage because with higher debt comes the higher amount of interest that needs to be paid. Leverage can be both good and bad for a business depending on the situation. If a firm is able to generate a higher return on investment (ROI) than the interest rate it is paying, leverage will have its positive effect shareholder’s return. The darker side is that if the said situation is opposite, higher leverage can take a business to a worst situation like bankruptcy.
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 .
Operating Leverage: Operating leverage, just like the financial leverage, is a result of operating fixed expenses. Higher the fixed expense, higher is the operating leverage. Like the financial leverage had an impact on the shareholder’s return or say earnings per share, operating leverage directly impacts the operating profits (Profits before Interest and Taxes (PBIT)). Under good economic conditions, due to operating leverage, an increase of 1% in sales will have more than 1% change in operating profits.
Formula for calculating operating leverage
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 .
Combined leverage: It is the product of operating leverage and financial leverage .
Formula for calculating combined 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 .
