CHAPTER – SEVEN

LEVERAGE D
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 THE CONCEPT OF LEVERAGE:
The leverage concept is very general. It is not limited to finance, or
business, in general. It can be used to analyze different types of
problems.
For instance, other disciplines, such as economics and engineering
use the same concept in treating/analyzing problems related to
their specific areas.
• In economics, leverage is referred to as elasticity.
• When used in financial setting, leverage measures the behavior of
interrelated variables, such as units sold, sales revenue, earnings
before interest and taxes (EBIT), and earnings per share (EPS).
The material in this chapter will be easily understood if you keep two points in your
mind. These are:
Leverage measures the relationship between two variables, as opposed to measuring
variables independently. The value of one variable must depend on the value of the
second variable.
In order for the leverage coefficients to have useful application you have to be able to
identify which variable is the dependent variable and which is independent. In
other words, the cause-effect relationship between the variables must be known.
When two variable are related one as cause and the other as effect the degree of
leverage describes the responsiveness of the dependent variable to changes in the
independent variable.
Leverage Defined:
Consider that Y and X represent two variables. When the values taken by Y are
determined/influenced by the values taken by X, then you can say that Y depends on
X. Accordingly, Y is the dependent variable and X is the independent variable. The
algebraic statement of the dependence of Y on X is. Written as:
Y = F(X), and read as "y" is the function of "x".