MEANING AND DEFINITIONS OF LEVERAGE:

Leverage in business is derived from the word ‘lever’. A lever is a simple tool by which a large
weight can be moved with a small force.
The study of Leverage starts with our understanding of break-even or the point at which a firm
covers both fixed and variable costs.
Leverage may be defined as 'meeting a fixed cost or paying a fixed return for employing
resources or funds. The fixed cost or fixed rerun is treated as support on which a lever moves. In
other words, the term leverage is used to describe the firm’s ability to use fixed costs assets or
funds to increase the returns to its owners i.e equity shareholders.
Leverage calculations is related to changes in sales to changes in various levels of income.

According to Solomon Ezra, “Leverage is the ratio of the net rate of return on shareholders
equity and the net rate of return on capitalisation.”

TYPES OF LEVERAGES

There are three types of leverages, such as

a) Operating Leverage
b) Financial Leverage
c) Composite Leverage

OPERATING LEVERAGE:

Operating leverage results from the presence of fixed costs that help in magnifying net operating
income fluctuations flowing from small variations in revenue. Hence, operating leverage may be
defined as the firm’s ability to use operating costs to magnify the effects of changes in sales on
its earnings before interest and tax.

According to Solomon Ezra, “Operating leverage is the tendency of the operating profit to vary
disproportionately with sales.”
FINANCIAL LEVERAGE

Financial Leverage is the degree to which a business is utilizing borrowed money rather than
equity to fund its operations. It reflects the amount of debt used in the capital structure of the
firm. Debt is used to magnify the rate of return on shareholders' equity.

According to Lawrence, “Financial leverage is the ability of the firm to use fixed financial
charges to magnify the effects of changes in EBIT on the firm’s earning per share.”

COMPOSITE LEVERAGE

When financial leverage is combined with operating leverage the effect of a change in output
(sales) in magnified in the change in earning per share (EPS). Operating leverage gives us the
change in EBIT with a change in sales and financial leverage gives us the change in EPS with a
change in EBIT. We can then see the change in EPS for a change in sales (volume of output).