Leverage is defined as a technique that inflates a company’s performance in terms of profit and loss; Used to describe a company’s use of debt to expand profits (financial leverage), or the use of a firm’s fixed assets (such as machinery) to achieve the same goals (operating leverage). In general, an increase in leverage means an increase in reward and risk, and vice versa.
A firm’s costs are divided into variable costs (which vary according to production) and fixed costs. Operating leverage occurs when a company has fixed costs that increase as costs increase, allowing the company to make higher profits from each additional sale. Managers use operating leverage to find the break-even point (the point at which total revenue equals total cost and zero profit), which helps managers estimate the effectiveness of the company’s product pricing structure; A small decrease in sales can lead to a significant decrease in profits; Leverage rises sharply and can also have a negative effect, leading to losses and possibly bankruptcy of companies, so there are no hard and fast rules for determining the safety of leverage; But we can say that in a prosperous economy, leverage increases profits at the expense of a lot of money. Firms that buy fixed assets like real estate and machinery have no control over consumer demand and hence their profits can fall. Economic slowdown due to higher fixed costs and lower sales.
- How to Calculate Leverage:
There are two ways to calculate leverage.
First: Operating Leverage = (Sales – Variable Costs)
Profit II: Change in Profit/Change in Sales A number derived from one of the two equations – eg, set to “4” – is interpreted so if sales increase by 10%, this will result in a 40% increase in profit.
Financial leverage occurs when a company has fixed financing costs, such as interest on debt, and is a tool that enables financial managers to increase their return on equity. The decision to increase the leverage depends to a large extent on the operating leverage, and if the operating leverage is high, the company plans to reduce the leverage, and vice versa. Basically, the leverage is compared to the company’s return on assets to see if the company can generate higher profits for the capital it is using.
- How to calculate the financial leverage: * Financial leverage: * Debt / Equity is the ratio of the company’s borrowed funds to shareholders’ equity, and with an increase in this ratio, the risks to the company’s financial position increase. * Leverage: * Percentage change in earnings per share / change in EBIT ratio. The higher the score, the more sensitive the company is to changes in operating income.
Leverage is also used to improve the credit rating of the company; When a company takes on debt and is able to pay it back on time through earnings, its credit rating rises and lenders’ confidence in it increases. Leverage helps in improving the company’s cash flow, investing capital, expanding projects, and achieving higher profitability.