Meaning of Leverage
Leverage refers to the use of fixed-cost instruments to maximise the return potential for the shareholders. In the world of finance, the word “leverage” has various variables such as revenue, costs, earnings before interest and tax (EBIT) and output quantity have an impact on the returns available to the shareholders. The study of leverage involves the quantification of the interrelationship between two or more variables. The formula for calculating leverage:
Leverage = %Change in Dependent Variable / % Change in Independent Variable
Definition of Leverage
According to Ezra Soloman, “Leverage is the ratio of the net rate of return on shareholders equity and the net rate of return on total capitalisation”.
According to J.E. Walter, “Leverage may be defined as percentage return on equity to percentage return on capitalisation”.
According to James C. Van Horne, “Leverage may be defined as the employment of an asset of funds for which the firm pays cost or fixed return. The fixed cost or return may be thought of as the fulcrum of lever”.
Types of Leverage
The main types of leverage and their various characteristics are as follows:
- Financial Leverage
- Operating Leverage
- Combined Composite Leverage
Financial Leverage
Financial Leverage is related to the financial structure of the firms. Financial Leverage is also known as trading on equity. It is concerned with the use of financial instruments with fixed costs of returns to maximise EBIT. Financial leverage is higher for the firms bending towards charge financial instruments A firm can achieve high financial leverage by making more use of financial products such as debentures and preference share capital which are bearing fixed costs. Fixed financial costs can result in a higher than proportional change in a company’s Earnings per Share (EPS), in response to a change in its Earnings Before Interest and Taxes (EBIT).
Firms with a financial leverage of 2, will experience a 200% change in their EPS with every 100% change in their EIT. Thus, the firm will see higher fluctuation in its EPS, in comparison to the firms with lower financial leverage. Financial leverage determines the rate of change in a firm’s EPS due to changes in its EBIT. This change is present due to fixed financial charges. A company that has no fixed financial charges does not even have financial leverage.
According to J.E. Walter, “Financial leverage may be defined as a percentage return on equity to the percentage return on capitalisation”.
According to James C. Van Horne, “Financial leverage involves the use of funds obtained at a fixed cost in the hope of increasing the return to common stock-holder”.
Thus, higher financial leverage is helpful if the firm can generate higher returns than the fired financial expenses. If the rate of earnings is equal to the rate of payment to be paid on fixed-income instruments, then it is the indifference point.
Characteristics of Financial Leverage
The major characteristics of financial leverage are given as follows:
1) Sources of Capital: Financial leverage is dependent on the composition of the liability side of the balance sheet. Companies that have higher fixed costs display higher financial leverage.
2) Based on Fixed Cost Capital: Financial leverage is dependent on the existence of fixed cost capital. No fixed cost capital, no financial leverage.
3) Direct Relation between Financial Leverage and Risk: Higher financial leverage indicates higher financial risk and vice versa.