In finance, leverage is a general term for any technique to multiply gains and losses.

[1] Common
ways to attain leverage are borrowing money, buying fixed assets and using derivatives.[2]
Important examples are:

 A public corporation may leverage its equity by borrowing money. The more it borrows,
the less equity capital it needs, so any profits or losses are shared among a smaller base
and are proportionately larger as a result.[3]
 A business entity can leverage its revenue by buying fixed assets. This will increase the
proportion of fixed, as opposed to variable, costs, meaning that a change in revenue will
result in a larger change in operating income.[4][5]

Leverage can be defined as “the employment of an asset or source of funds for which the firm
has to pay a fixed cost or fixed return”. Because of the incurrence of fixed costs, the net income
and the earnings available to the equity shareholders as well as the risk gets affected. Leverage is
favorable when the earnings less the variable costs exceed the fixed costs or when the earnings
before interest and taxes exceed the fixed return requirement. Leverage is unfavorable in the
reverse situation.

Leverage can be of two types – Operating & Financial leverages.

1. Operating leverage - The leverage associated with investment, i.e., asset acquisition
activities is called as operating leverage.

2. Financial Leverage - the leverage associated with financing activities is called as

financial leverage.

Combined leverage – This is the product of the operating and financial leverages
Financial leverage is related to the financing activities of the firm. It is caused due to fixed
financial costs in the firm. The sources of such types of funds carrying a fixed interest cost are
long-term bonds and debentures. These financial fixed charges do not vary with the earnings
before interest and taxes or sales. They have to be paid irrespective of the profits available.
Financial leverage is concerned with the effects of changes in EBIT on the earnings available to
the equity shareholders. It can be defined as "the ability of the firm to use the fixed financial
charges to magnify the effects of changes in EBIT on the firm's earnings per share (EPS)". In
other words, financial leverage involves the use of funds obtained at a fixed cost with a hope of
increasing the returns available to the equity shareholders.

A favorable financial leverage occurs when the firm earns more on the assets purchased with the
funds, than the fixed cost of their use. Unfavorable leverage occurs in the reverse scenario. In a
way, use of fixed cost source of funds generates increased returns for the equity shareholders
without an additional requirement of finance from them. Therefore, financial leverage is
alternatively also called as 'Trading on equity'.

Degree of Financial leverage

The degree of financial leverage can be expressed as the percentage change in Earnings per share
divided by the percentage change in the firm's earnings before interest and taxes.

If DFL > 1, financial leverage exists.

The greater the DFL, higher is the financial leverage for the firm.

Operating Leverage

Operating leverage is the leverage associated with investment activities. Operating leverage can
be determined by the relationship between a company's sales revenue and its earnings before
interest and taxes. EBIT is also termed as operating profit. Operating leverage results from the
existing of fixed operating expenses. The operating leverage can also be said as the firm's ability
to use the fixed operating costs to magnify the effects of changes in sales on its earnings before
interest and taxes. A firm employs or invests in fixed assets hoping that the profits generated
from those assets would cover the fixed costs of operating them as well as the variable costs.

Example:

A firm selling price of its product is $100 per unit. The variable cost per unit is $50 and the fixed
operating costs are $50,000 per year. Let us evaluate the EBIT resulting from sale of 1) 1000
units 2) 2000 units & 3) 3000 units.
Results:

From case 2 to case 3: An increase in sales by 50% (from $200,000 to $300,000) resulted in an
increase in EBIT by 100% (from $50,000 to $100,000).

From case 2 to case 1: A decrease in sales by 50% (from $200,000 to $100,000) resulted in a
decrease in EBIT by 100% (from $50,000 to $0).

This relationship between the increase/decrease in sales and change in EBIT is called as
operating leverage.

Degree of Operating leverage

Degree of operating leverage can be expressed as the percentage change in EBIT divided by the
percentage change in sales. If the proportionate change in EBIT as a result of a given change in
sales is more than the proportionate change in sales, operating leverage exists.

If DOL > 1, operating leverage exists.

The greater the DOL, the higher is the operating leverage.

Calculation of degree of operating leverage:

Example:

With the same figures given above, we can calculate the operating leverage.

Percentage change in EBIT = ($100,000 - $50,000)/$50,000 x 100 ⇒ 100%

Percentage change in Sales = ($300,000 - $200,000)/$200,000 x 100 ⇒ 50%

DOL = 100% ⁄ 50% = 2

An operating leverage of 2 indicates that for every $1 change in sales there would be $2 change
in EBIT in the same direction

Combined Leverage

Combined leverage, as the name implies shows the total effect of the operating and financial
leverages. In other words, combined leverage shows the total risks associated with the firm. It is
the product of both the leverages.

Degree of Combined Leverage (DOL) = DOL * DFL

    

As represented above, the degree of combined leverage measures the percentage of change in
Earnings per share as a result of a percentage change in Sales. The combined leverage can work
in either direction. It would be favorable if sales increase and unfavorable in the reverse scenario.
It serves as an important measure in choosing financial plans as EPS measures the ultimate
returns available to the owners of the company. For example, if the company invests in more
risky assets than usual, the operating leverage of the company will increase. If the company does
not change its capital structure, the financial leverage will not change. These two actions will
increase the combined leverage of the firm, as a result of increase in the operating leverage.

As said, the combined leverage measures the total risk of the firm. If the firm wants to maintain
the risk or not to increase the risk, it would try to lower the financial leverage to compensate for
the increase in operating leverage so that the combined leverage remains the same. Lowering the
financial leverage can be done if the new investments are made in equity rather than debt.
Similarly, in cases where the operating leverage has decreased due to lower fixed operating
costs, the firm can think of having a more levered financial structure and still keep the combined
leverage constant, thereby increasing the earnings per share of the equity holders. These are the
advantages of measuring the combined leverage.

Example :

A firm selling price of its product is $100 per unit. The variable cost per unit is $50 and the fixed
operating costs are $50,000 per year. The fixed interest expenses (non-operating) are $25,000
and the firm has 10,000 shares outstanding. Let us evaluate the combined leverage resulting from
sale of 1) 2000 units & 2) 3000 units. Tax rate = 35%.
    
A combined leverage (total risk) of 4 indicates that for every $1 change in sales, there would be a
$4 change in the Earnings per share in either direction.