What Is Leverage

Definition of Leverage

Leverage refers to employment of an asset or source of funds for which the enterprise has to pay a fixed cost or fixed return. In other words, it refers to a relationship between two variables. Such variables may be cost, output, sales, revenue, earnings before interest and taxes (EBIT), earnings per share (EPS), etc.

Explanation

Financing decisions are based on two important aspects:

1. Quantum of funds needed.
2. The method of raising such funds – say, to decide the sources or their combinations.

If an enterprise is able to estimate how much capital fund are needed, the next problem would be to decide the best mix of different sources to be used in raising the estimated capital fund. This process is called capital structure planning. generally, two type of techniques are widely used:
(a). Leverage analysis
(b). EBIT – EPS analysis

What Is Leverage Analysis?

In the leverage analysis, the emphasis is on the measurement of the relationship of two variables rather than on measuring these variables. If leverage study should serve a useful purpose, the two variables for which the relationship is to be established and measured should be interrelated.
If the variables are not interrelated, the leverage analysis will serve no purpose. Leverage may be analyzed thus, as the percentage change in the variable divided by the percentage change in some other variable. Here, the numerator is the dependant variable and the denominator is the independent variable.

Example

For example, an enterprise increases its advertising expenses from $100,000 to $120,000, i.e., an increase of 20%, which resulted in the increase of units sold from 500 to 750, i.e., an increase of 50%. Then calculation of leverage is done as follows:

Here, the percentage of increase in the number of units sold is 2.5 times that of the percentage increase in advertising expenses. This illustrates that the leverage is favorable. It means a lower percentage of increase in the variable cost has resulted in a higher percentage of increase in sales which is bound to enhance earnings. This indicates that the operating profit of an enterprise is a direct consequence of the sales revenue.

What Is Favorable and Unfavorable Leverage?

Favorable leverage means earnings before interest and taxes exceed the fixed return requirement. In other words, earning less variable costs exceed the fixed costs.
If the earnings less the variable costs do not exceed the fixed costs, the leverage is considered to be unfavorable.

EBIT – EPS Analysis

It is the operating profit that determines the profit available to shareholders. this can be illustrated from the following tabular representation:

Note: It is the earnings after tax which is available to equity shareholders for distribution.
Thus, earning per share (EPS) = Profit after tax / No. of shares eligible for distribution of profit to shareholders.
The statement illustrated above shows the functional relationship between the ‘sales revenue‘ and EPS, which is established through operating profits (EBIT).

Most Commonly Used Leverages

As the basic objective of the management of an enterprise is to maximize the shareholder’s wealth, it is necessary to maximize the market price of the shares by maximizing EPS. Thus, leverage helps the management to make a decision in this regard. Most commonly used leverages are:

1. Operating Leverage
2. Financial Leverage

Sometimes managers make use of combined leverage also.

How to Evaluate the Result of Leverages

1. High operating leverage and high financial leverage: This situation indicates high risk. Any slight change in sales or contribution may affect the EPS to a large extent. To the extent possible the manager should avoid this situation.
2. High operating leverage and low financial leverage: In this situation, the existence of high fixed cost may affect EBIT, if there is a slight decrease in sales or contribution. This slight change may be taken care of by using the low cost debt.
3. Low operating leverage and high financing leverage: This situation may be considered an ideal situation because the company has taken the risk of borrowing more debt capital in order to increase EPS. Any slight decrease in sales or contribution may not affect EBIT to a large extent, as the component of fixed cost is negligible in the cost structure.
4. Low operating and low financial leverage: This situation indicates the very cautious policy being followed by the manager, i.e., the policy of contentment. Any slight decrease in sales or contribution, may not affect the EBIT to a large extent as the fixed cost component is negligible in the overall cost structure. Simultaneously, the manager has not taken high risk in formulating the capital structure.
5. Combined leverage: While making decisions based on combined leverage, the manager should be cautious to note the influence of operating and financial leverages. If the influence of the financial leverage is slightly high, the result of the combined leverage may be taken for a positive decision.
However, the manager should use the leverage analysis based on the company’s ability to take risk to maximize the wealth of the shareholders and reduction in cost structure to enhance EBIT. The manager should not be influenced only by the high rate of EPS while making decisions.

Important Formulas Used in Leverage Analysis (At a Glance)

Operating Leverage = Contribution / EBIT
Degree of Operating Leverage (DOL) = % Change in EBIT / % Change in sales revenue
Financial Leverage (FL) = EBIT / EBIT – I
Alternatively,
FL = EBIT / EBT
Alternatively,
FL  = EBIT / (EBIT – Financial Charges)
If the company uses preference shares in its capital structure, preference dividend should also be included in the financial charge. Under such circumstances, financial leverage is calculated as:
FL = EBIT / (EBIT – D ÷ (1 – t))
Note: If preference dividend is attracted by dividend tax, such tax should be added to preference dividend.
Degree of Financial Leverage = % Change in EPS / % Change in EBIT
Total or Composite or Combined Leverage = OL x FL
Alternatively,
CL = (Contribution / EBIT) x (EBIT / EBT) = Contribution / EBT