LEVERAGEObjective of financial management is to maximize wealth. Here wealth means market value. Therefore, to maximize volue compony should try to manage its risk. This risk may be business risk, financial risk or both.
Meaning of leverage
In financial analysis, leverage represents the influence of one financial variable over some other related financial variable. These financial variables may be costs, output, sales revenue, Earnings Before interest and Tax (EBIT), Earning per share (EPS) etc
According to J. C. Van Home: “Leverage is the employment of an asset or funds for which the firm pays a fixed cost of fixed return.”
The word ‘leverage’, borrowed from physics, is frequently used in financial management
Types of Leverage
a) Operating Leverage
b) Financial Leverage
c) Combined Leverage
1. Operating Leverage:
Operating leverage refers to the use of fixed operating costs such as depreciation, insurance of assets, repairs and maintenance, property taxes etc. in the operations of a firm. But it does not include interest on debt capital. Higher the proportion of fixed operating cost as compared to variable cost, higher is the operating leverage, and vice versa
Definition of Operating leverage
2. Financial leverage
Financial leverage is the use of debt to buy more assets. Leverage is employed to increase the return on equity. ... The financial leverage formula is measured as the ratio of total debt to total assets. As the proportion of debt to assets increases, so too does the amount of financial leverage
Definition of financial leverage
According J.E.Walter: Finanacial leverage may be defined as percentage return on equity to the percentage returns on capitalisation.
According to James C Van horne, Finanacial leverage involves the use of funds obtained at a fixed cost in hope of increasing the return to common stock holders.
3. Composite Leverage super leverage:
Both financial and operating leverage magnify the revenue of the firm. Operating leverage affects the income which is the result of production. On the other hand, the financial leverage is the result of financial decisions.
The composite leverage focuses attention on the entire income of the concern. The risk factor should be properly assessed by the management before using the composite leverage. The high financial leverage may be offset against low operating leverage or vice-versa.
The degree of composite leverage-can-be.calculated as follows:
Degree of Composite Leverage (DC Change in Sales Percentage Change in EPS/percentage
Or, Composite Leverage = Operating Leverage X Financial Leverage
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