Leverage 

What is leverage 

Leverage is the investment strategy of using borrowed money: specifically, the use of various financial instruments or borrowed capital to increase the potential return of an investment. Leverage can also refer to the amount of debt used to finance assets. When one refers to something (a company, a property or an investment) as "highly leveraged," it means that item has more debt than equity.

There are three types of leverage 

1. Financial Leverage 
2. Operating Leverage 
3. Combined Leverage 

Financial Leverage 

Financial leverage is mainly related to the mix of debt and equity in the capital structure of a firm. It exists due to the existence of fixed financial charges that do not depend on the operating profits of the firm. Various sources from which funds are used in financing of a business can be categorized into funds having fixed financial charges and funds with no fixed financial charges. Debentures, bonds, long-term loans and preference shares are included in the first category and equity shares are included in the second category

Financing decision goes in favour of employing funds having fixed financial charges because it can be used as a lever. Financial leverage results from the existence of fixed financial charges in the firm’s income stream. With the use of fixed financial charges, a firm can magnify the effect of change in EBIT on change in EPS. Hence financial leverage may be defined as the firm’s ability to use fixed financial charges to magnify the effects of changes in EBIT on its EPS.

The higher the proportion of fixed charge bearing fund in the capital structure of a firm, higher is the Degree of Financial Leverage (DFL) and vice-versa. Financial leverage is computed by the DFL. DEL expresses financial leverage in quantitative terms. The percentage change in the earning per share to a given percentage changes in earnings before interest and taxes is defined as Degree of Financial Leverage (DFL). 

Operating Leverage 

Operating leverage is concerned with the investment activities of the firm. It relates to the incurrence of fixed operating costs in the firm’s income stream. The operating cost of a firm is classified into three types: Fixed cost, variable cost and semi-variable or semi-fixed cost. Fixed cost is a contractual cost and is a function of time. So it does not change with the change in sales and is paid regardless of the sales volume. 

Variable costs vary directly with the sales revenue. If no sales are made variable costs will be nil. Semi-variable or semi-fixed costs vary partly with sales and remain partly fixed. These change over a range of sales and then remain fixed. In the context of operating leverage, semi-variable or semi-fixed cost is broken down into fixed and variable portions and is merged accordingly with variable or fixed cost. Investment decision goes in favor of employing assets having fixed costs because fixed operating costs can be used as a lever.

With the use of fixed costs, the firm can magnify the effect of change in sales on change in EBIT. Hence the firm’s ability to use fixed operating costs to magnify the effects of changes in sales on its earnings before interest and taxes is termed as operating leverage. This leverage relates to variation in sales and profit. Operating leverage is measured by computing the Degree of Operating Leverage (DOL). DOL expresses operating leverage in quantitative terms. 

The higher the proportion of fixed operating cost in the cost structure, higher is the degree of operating leverage. The percentage change in the earnings before interest and taxes relative to a given percentage change in sales and output is defined as the DOL

Combined Leverage 

A firm incurs total fixed charges in the form of fixed operating cost and fixed financial charges. Operating leverage is concerned with operating risk and is expressed quantitatively by DOL. Financial leverage is associated with financial risk and is expressed quantitatively by DFL. Both the leverages are concerned with fixed charges. If we combine these two we will get the total risk of a firm that is associated with total leverage or combined leverage of the firm. Combined leverage is mainly related with the risk of not being able to cover total fixed charges. 

The firm’s ability to cover the aggregate of fixed operating and financial charges is termed as combined leverage. The percentage change in EPS to a given percentage change in sales is defined as Degree of Combined Leverage (DCL). DCL expresses combined leverage in quantitative terms. The higher the proportion of fixed operating cost and financial charges, higher is the degree of combined leverage. Like other two leverages the value of combined leverage must be greater than.