Leverage

If we understand them in a simple language than, Leverage is an investment

strategy for using borrowed money. We can also say that, amount of debt a
firm uses to finance their asset.
Employment of an asset or source of funds
for which
the firm has to pay fixed cost or fixed return
may be termed as
Leverage
Let’s understand with a small example.
Dhruv want to start a burger restaurant, but he doesn’t have sufficient money, so he
borrowed 10,00,000Rs. From HDFC BANK. And bought the Restaurant &
Equipment’s for starting the restaurant. Now as per today’s value Total Asset is
20,00,000 and Total Liability is 10,00,000.

10,00,000(Total Liability )
Leverage: 20,00,000(Total Assets)

Leverage: 0.5
Higher leverage is Not good sign for a company.
Lower leverage is good sign for a company.

Leverage

Operating Financial Combined

Leverage Leverage Leverage

Associated with Associated with Combination of

Investment Sources of Fund both leverage
Operating Leverage:
As we know that, there are 2 types of costs occurred in the company.
1. Fixed Cost
2. Variable Cost
Operating leverage has only concerned with the Fixed Cost.
Let’s make this clear.
In simple words Ratio of Fixed Cost to Variable cost is Operating Leverage.
If firm have Higher fixed cost compare to the variable cost than firm can say that
they have a higher operating leverage.

¿ Cost
Operating Leverage: Variable Cost

Now, we are moving towards the Degree of Operating Leverage (DOL)

Degree of Operating Leverage:

EBIT (Earning before Interest & Taxes) changes with change in Sales.
If Sales increase EBIT increases
If Sales Decrease EBIT Decreases.

In simple words DOL is used to know that, How much % change in EBIT when
1% change occurs in Sales.

This formula is used to measure the effect of variation in sales volume on the
level of EBIT
 High degree of OL is welcomed when Sales is rising
 High degree of OL is undesirable when Sales are Falling
 % change∈EBIT
Degree of Operating Leverage: % change∈Sales

Financial Leverage:
It refers to the utilization of borrowed money to acquire new assets which are
assumed to generate more Higher capital gain or income.
High ratio denotes that large amount of debt is used to finance its assets. Vice
versa.
Average Total Assets
Financial Leverage Ratio: Average Equity

Degree of Financial Leverage:

It is simply ability to check the effect of change in EPS while the EBIT changed.
% Change∈EPS
Degree of Financial Leverage: % Change∈EBIT

Combined Leverage:
This simply shows the change in EPS due to change in the Sales.
Degree of Combined Leverage: Degree of Operating Leverage * Degree of
Financial Leverage
Or
% Change∈ EPS
Degree of Combined Leverage: % Change∈ Sales