Definition of Financial Leverage: The general meaning of the word leverage is ‘influence’ or ‘power’. The English word Lever is derived from the French word Levier or Lever; Which means to raise. Although the word lever literally means Varaettalan Dutt. In general, we know that heavy objects can be lifted with a little force with the help of weight lifting rods. So.
What is Leverage?
It can be said that just as the lever increases the power, the debt capital can increase the number of dividends of the organization. For example, the use of a crane for loading and unloading cargo on a ship, the hydraulic back of a vehicle. And steering wheel etc. In a word, leverage is the performance or strategy of leverage.
The main purpose of financing management is to maximize the assets of shareholders. Investment decisions and financial decisions are both specifically related to the concept of asset maximization. According to experts, total earnings and earnings per share (EPS) depend on the effectiveness of the decision. In addition, the company’s fixed operating cost and fixed financial cost play a special role in increasing the income of shareholders. This means that the ability of shareholders to use fixed assets or funds to increase their income is called leverage.
This refers to fixed expense assets (buildings, furniture, equipment) and fixed expense funds (debt capital and preferred share capital).
Various financing experts have provided definitions of leverage. Below are some definitions of Leverage.
M.Y. Khan and P. K Jain Say, “Leverage is the employment of an asset/source of finance for which firm pays fixed cost / fixed return.
J. C. Van Horne and J. M Wachowicz, Jr. Says,” Leverage is the use of fixed costs in an attempt to increase (or lever up) profitability. “
L. J. Gitman Says, “Leverage results from the use of fixed cost assets or funds to Imagnify returns to the firm’s owners.” That is, the emergence of leverage is the result of the use of fixed expenses or funds to increase the owner’s income.
According to Block and Hirt, “Leverage is the use of fixed charge items with the intent of Imagining the potential returns to the firm.” That is, leverage is the use of fixed-cost funds to increase potential income.
According to Webster’s Dictionary, “Lever is an inducing or compelling force and leverage is the action of a lever or the Mechanical advantage gained by it.” That is, leverage is a firm. The ability of shareholders to use their fixed expense assets or funds to increase their income.
Therefore, analyzing the above discussion and definitions, it can be suggested that leverage is the strategy or effort to maximize the earnings per share i.e. the firm’s wealth through the use of fixed cost assets and fixed financial cost funds. .
Discuss the Different Types of Leverage:
Before discussing the types of leverage, we need to know what kind of fixed costs an organization can incur. Because leverage is related to the organization’s fixed costs. We know that the fixed cost of an organization is divided into two parts.
A. Operating fixed cost; Such as salary, rent, machinery. Depreciation costs incurred, etc.
B. Financial fixed costs such as interest on borrowed capital and preference dividends paid for preferred share capital.
Therefore, leverage can be divided into three categories on the basis of the above two types of fixed costs.
- 1. Operating leverage
- 2. Financial leverage
- 3. Combined / Total leverage.
The following three types of leverage are discussed in detail:
1. Description Of Operating Leverage:
The relationship of fixed costs with the variable costs of any organization is called management or effective leverage. In other words, effective leverage is the special ability of an organization to use fixed operating cost, which is the increase in the number of sales that the organization earns before interest and tax (EBIT) and net Increases the amount of Net Operating Income (NOI).
Therefore, it can be said that interest and pre-tax income (EBIT) is higher than the growth rate of sales as a result of an increase in fixed operating expenses. If the growth rate is high then the result of leverage will be positive. Conversely, if the growth rate of income (EBIT) is lower than the growth rate of sales, then the result in leverage will be negative.
Below are the definitions of different authors:
J. C. Van Horne and J. M. Wachowicz, “Operating leverage is the use on fixed operating costs by the firm.” That is, the use of fixed operating expenses by the firm is called operating leverage or effective leverage.
L. J. Gitman, “The potential use of the fixed operating cost to magnify the effects of changes in sales on the firm’s earnings before interest and taxes.” That is, operating leverage refers to the firm’s ability to use fixed operating expenses, which increase interest and pre-tax income as sales increase.
Ross, Westerfield, and Jordan, “Operating leverage is the degree to which a project or firm is committed to fixed production costs.”
M. Y. Khan and P. K. Jain, “Operating Leverage is caused due to fixed operating expenses in a firm.” That is, operating leverage is the result of fixed operating costs in a firm.
From the above discussion and definitions, it can be said that operating leverage is the ability of an organization to increase its pre-tax and pre-tax income at a higher rate by increasing the sales volume as a result of using fixed operating expenses. If operating costs change, so do profits, in which case operating leverage is created.
Therefore, it can be said that there is no operating leverage if there is no fixed cost.
Features of Operating Leverage:
The following characteristics are observed when reviewing the definition of operating leverage.
A. Relation with fixed operating costs:
The relationship between operating or work leverage is fixed. In other words, the higher the fixed operating expenses, the higher the level of leverage, the higher the curve, and the higher the income. The reason for this is that in this case, the current cost of the organization is less. As a result of having fewer running expenses, the contribution of the organization will be more and with more contribution, it is possible to earn more profit by meeting the fixed operating expenses.
B. No leverage:
If an organization does not have a fixed operating cost of the cost structure, then that organization will have no leverage. That is, the leverage will be 0 (zero) and the level of leverage will be (DOL) = 1 Therefore, the change in sales rate and the change in profit rate will also change at the same rate. This chapter (Illustration-2) shows the presence and absence of fixed costs.
C. Maximum leverage at break even point:
In general, we know that any organization pays a loss even before the break-even point. The higher the sales from that point, the higher the profit. Therefore, near the point of intersection. Leverage tends to be higher.
D. Favorable / Positive leverage:
If the sales of a company increase, the profit will increase at a higher rate than the proportional rate. We can call this condition the favorable effect of leverage. However, if the condition is, in this case, the organization must have a fixed operating cost.
E. Negative leverage:
Symbolic leverage is the exact opposite of optimal leverage. In other words, if the sales of a company decrease with fixed operating expenses, the profit will be reduced at a lower rate than the proportional rate. This is what we call unfavorable leverage. Which is shown as DOL <1.
Management leverage is usually calculated by dividing the contribution margin by interest and taxable profit (EBIT).
G. The higher the level of leverage, the higher the risk and income (More degree of leverage, more risk and return):
The higher the level of operating leverage, the higher the chances of maximizing profits, the higher the risk. Therefore, it can be said that the level of leverage may not always be favorable. If sales decline, profits will fall at a higher rate if operating costs remain constant. However, in that case, the company will face business risks.
H. Effect of variable cost on contribution:
In the case of effective leverage, the effect of current expenditure on data is always analyzed. The lower the current expenditure, the higher the penalty. And if the cost is high, the percentage is low.
I. Adjustment of risk and return:
And if the organization uses management leverage, the risk of leverage can also be adjusted to profit. The higher the operating leverage, the higher the risk. However, the profit is higher. Of course, the lower it is, the lower the risk and the lower the profit.
May be Clear Now This Question What are the features of management leverage? What are the features of operating leverage?.
Operating Leverage Measurement Methods:
In order to measure effective or manageable leverage, its level has to be measured. So we need to know the level of management leverage.
What is Degree of operating leverage?
Effective leverage measurement and its interpretation are very important for a financial manager of an organization to reach its goals. Increasing sales will increase profits, which is a normal process.
However in this case the amount or presence of fixed expenditure affects. Resulting in the emergence of management leverage. Therefore, the level of operating leverage refers to the percentage of change in profit due to a change in sales at a fixed percentage.
In this context, the definition of some writers is given below:
Van Horne and Wachowics Say, “The percentage change in a firm’s operating profit (EBIT) resulting from a 1 percent change in output (Sales).” That is, a 1 percent change in production (sales) changes the percentage of the firm’s operating profit.
M. Y. Khan and P. K. Jain Say, “When a proportionate change in EBIT as a result of a given change in the sale.
2. What Is Financial Leverage?
Financial Leverage Financial leverage is the leverage created as a result of fixed financial expenses. Here the relevant financial fixed expenses are completed. It is important to have an idea.
In the above content, we have seen the financing decision as one of the most important issues in the various decisions of a financial manager. Which is accomplished as a long-term goal of the firm. It plays a special role in maximizing or increasing the income of shareholders.
Note that, in general, long-term financing
- i. Retained income
- ii. Ordinary share capital.
- iii. Priority share capital
- iv. Loan capital (bond sale or bank loan)
These four types of sources are used. The use of debt capital and preferred share capital among the described sources means that the company has to bear a fixed financial cost.
For example, in the case of long-term financing, the company has to bear the fixed financial expenses at a fixed interest rate or interest rate.
On the other hand, when money is raised through priority shares, it is seen that the dividends of the owners of those shares have to be paid before the dividends due to the ordinary shareholders, which is considered as a fixed financial expenditure.
Financial leverage can therefore be defined as a combination of equity capital and debt capital in long-term financing. The process of increasing the earnings or earnings per share of ordinary shareholders is called financial leverage.
The following are the definitions of some of the financing authors:
Van Horne and Wachowicz Says,
“Financial leverage means the use of fixed financing costs by the firm.” That is, financial leverage is the use of fixed financial expenses by the firm.
According to L. I. Gitman,
“Financial leverage is defined as the potential use of fixed financial costs to magnify the effect of changes in earnings before interest and tax (EBIT) on the firm’s earnings per share (EPS).” That is, financial leverage maximizes the response to earnings per share on pre-tax earnings using financial expenses.
M. Pandey Say,
“The use of fixed change sources of funds such as debt and preference capital along with the owner’s equity in the capital structure is described as financial leverage or trading on equity.”
That is, a fund consisting of fixed expenses with the owner’s capital in the capital structure. Financial leverage such as debt and use of priority capital.
According to Leverage LF Weston, Scott Besley and Brigham,
“Financial leverage is created when a firm has fixed financial costs associated with its financing characteristics.” That is, when a firm incurs a fixed cost in the financing process, financial leverage is created.
In view of the above discussion in this content, it can be said that the financial leverage of any company depends on the capital structure. Which is defined by the ratio of debt capital to owner capital.
Therefore, it can be said that financing the assets of a company through loans is called financial leverage.
Now maybe clear this Question. What is financial leverage?
Features of Financial Leverage:
Analyzing the definition of financial leverage, some special, distinctive features are observed. We know that if an organization does not have debt, then financial leverage does not arise.
The interest on the loan is the fixed financial cost of the capital structure of the organization. The features of financial leverage are discussed below:
A, It is part of capital structure:
Of course, it must be part of the organization’s capital structure. Only then can the firm be at financial risk and acquire the capacity to bear it. Is trying to. As a result, the firm’s profitability increases. |
B, Financial risk:
The institution is obliged to pay interest or dividend, respectively, for the loan or preference shares. If the firm has a higher rate of income than the rate of interest repayment of the loan in the corresponding year. If the rate is significantly lower, the impact of financial leverage on the firm will be negative. As a result, financial backlash is created.
C, Debt capital:
Borrowed capital is one of the characteristics of financial leverage. Because financial leverage will only happen when financially spent funds exist. Therefore, borrowed capital is financial. Source of leverage.
Financial leverage is basically a fixed percentage of interest and pre-tax income (EBIT). The change determines the percentage change in earnings per share. Therefore, it can be said that interest and taxes. There is a close relationship between previous earnings and earnings per share. .
The effects of financial leverage can be either positive or negative. The effect of financial leverage also varies when the rate of income is lower than the rate of interest.
In addition to borrowed capital, the source of financial leverage is considered to be the sale of preferred shares and long-term financing from various financial institutions.
G, Degree measurement:
There is a different way to measure the level of financial leverage, which is not in the opinion of management leverage.
Financial leverage affects the long-term capital structure. Because. Borrowed capital is invested in fixed assets.
I, Proportionate rate:
Financial leverage is the equity capital to debt ratio in the capital structure.
J. Leverage at second stage:
Management Leverage The first level of leverage is considered because of the relationship of profit with sales. In the case of financial leverage, the second level of leverage is considered to be the relationship between earnings per share (EPS) and profit.
From the above discussion, it is evident that financial leverage has many features of its own, which have differentiated its method, dimensions, and advantages disadvantages.
Although the use of financial leverage is not essential or inevitable for any company.
Now maybe clear this Question guys, Describe the features of financial leverage. Yet any questions contact us.
Advantages and Disadvantages of Different Measures of Financial Leverage Lets See:
As we have seen in the above
discussion in this article, financial leverage is associated with Owner’s Equity. Consider the debt relationship. There are several widely used methods for considering this relationship.
These are discussed in detail below.
A, Debt to total capital ratio:
This method is one of the methods of measuring financial leverage. In this way financial leverage can be expressed in market or book value. The theoretical evaluation of financial leverage at market price is more acceptable. However, some of the advantages of this method. There are difficulties. It is mentioned below:
- 1. This is more acceptable to investors because they will invest in less financially risky options. Normal.
- 2. This reflects the current attitude of the investors.
- 3. The loan status of the firm is known at a specific time.
- 1. Fails to provide guidance on appropriate financial risk.
- 2. ‘The market price concept can be questioned due to lack of information.
- 3. The market value concept is not effective in this case as the market price of the investment fluctuates rapidly.
B, Debt to equity ratio:
In terms of popularity, the debt-to-ownership ratio method is more popular. This method measures the dependence of the firm on its borrowed capital.
- 1. It is easy to know how much the firm’s mortgage depends on debt.
- 2. Loan interest and priority are mandatory for shareholders to pay interest and dividend respectively. Therefore, what can be considered as a result of the change in the rate of dividend paid on ordinary share capital.
- 3. the firm is known to be risk-free or risk-free. Difficulty
- 1. In this method, the current liabilities will be considered in the loan to determine the ratio. No, there is a difference of opinion.
- 2. There may be disagreement over whether the preferred shares will be included in the ownership.
C, Net operating income to interest charges ratio:
This method is mainly used to determine the relationship between current income and current liability.
- 1.This method reflects the company’s ability to handle fixed financial liabilities.
- 2. Investors gain an idea of financial risk.
- 1. This method publishes the details of the mate’s income, not the cash flow data. –
- 2. Can not give the right direction about the future risks of the firm.
- 3. It is a measure of short-term liquidity rather than leverage.
Now Maybe Clear this Question. Discuss the advantages and disadvantages of different measures of financial leverage.
Factors Determining the Ideal Degree of Financial Leverage:
Financial leverage is very important to all stakeholders. So this is one of them. Determining the ideal value is vital. There are some determinants in determining this ideal value, it is necessary to be careful about those things. That regulators influence the level of financial leverage. Described:
A, Rate of return on assets:
The rate of earnings/profit on assets must be higher than the cost of borrowing funds. This is because if the rate of profit is high, the minimum acceptable level of financial leverage can be maintained.
In this case, the standard leverage level can be determined. On the contrary, leverage. Adverse effects are seen. In other words, the earnings per share of the organization decreases which is not desirable for any organization under any circumstances.
B, Earnings per share (EPS):
The standard of financial leverage needs to be set in such a way that the activities of the firm can be managed smoothly. Even if the earnings per share cannot be increased by deciding on earnings per share, it should remain unchanged. Therefore, earnings per share is one of the considerations when determining the standard value of financial leverage.
C, Rate of interest on loan:
This controller plays one of the most important roles in determining the ideal level. So it has to be taken seriously. The higher the interest rate on the borrowed funds, the higher the financial key.
When the interest rate of the loan and the dividend rate of the preferred share capital become equal. It would be profitable to use borrowed capital instead of preferred share capital.
D, Tax rate:
Variability in a country’s tax structure changes the standard leverage. The tax rate, therefore, serves as an important factor in determining the level of ideal financial leverage.
E, Stability of earning rate:
Interest in borrowed capital is a fixed cost. So financial. The stability of the profit rate is a very important factor in determining the level of leverage. Because of the rate of profit is volatile. Low income will be at hand to cover fixed expenses, which can bring huge risks for the organization.
F, Degree of operating leverage:
And in order to increase the profit per share at the expected rate, the desired growth of interest and pre-tax profit is required. And this requires a standard value of management leverage, which must be considered when determining the standard value of financial leverage.
If there is instability in cash flow, then there are various problems in the business, which force the organization to finance a lot of time. So cash in determining the financial leverage level. Flow is an important consideration. |
At the end of the above discussion, it can be said that it is not desirable for any party to use the level of financial leverage as it wishes. It is very important to set the standard of financial leverage by focusing on all the parties and giving importance to the issues discussed above.
Is Clear this Question Describe the factors that determine the level of standard financial leverage or Explain the factors determining the ideal degree of financial leverage Or, discuss the factors that determine the standard financial leverage of an organization.
Yet if you Don’t understand comments us, we are ready to help you.
3. Degree of Total Leverage (DTL):
Before discussing the level of matte or mixed or overall leverage, what is Total leverage? The overall concept of management and financial leverage in mixed leverage halls.
It has been argued that an increase in operating leverage results in a higher rate of interest and pre-tax (EBIT) growth than a growth rate of sales (Greater the degree of operating leverage, the more sensitive EBIT will be to change in sales) and an increase in financial leverage increases EBIT.
The EPS growth rate is higher than. Therefore, if a firm uses management and financial leverage at the same time, a small change in sales can increase EPS to a greater extent.
So the leverage that simultaneously reveals the results of management and financial leverage is called aggregate or matte or mixed leverage.
To clarify the concept of Total leverage, some authors define:
J. J. Hampton Say, “It combines the effects of operating and interest change leverage.”
L. J. Gitman Says, “Total leverage can be defined as the firm’s ability to use fixed costs, both operating and financial to magnify the effect of change in sales on the firm’s earnings per share.”
That is, Total leverage is the ability of the firm to use both fixed and costly operating costs. Which refers to a change in earnings per share as a result of a change in sales.
Burton A. Kolb, “Operating leverage multiplied by financial leverage equal total leverage.” That is, the product of management leverage and financial leverage is called Total leverage.
Weston. Besley and Brigham, “The percentage change in earnings per share that results from a given percentage change in sales it shows total leverage, shows the effects of both operating leverage and financial leverage.
From the above discussion and definition of Total leverage, it can be concluded that the use of the firm’s management and financial expenses by mixed leverage increases sales, and its effect on earnings per share is a mat or mixed. Is measured by leverage. Mathematically speaking
The level of leverage can be expressed as follows?
Total Leverage Level =
Management Leverage Level X Financial Leverage
Degree of Operating Leverage x Degree of Financial Leverage
DOL X DFL
Related Content In This Site:
Impact of Total Leverage:
How is a firm or organization structured in its capital structure and what is the capacity of the firm to bear the fixed expenses that it has to bear for it? The simple solution to this question is to determine the leverage of the firm.
We know which firm can use both management and financial leverage. In that case, his Total leverage increases. The level of Total or mixed leverage is determined by measuring how much mate he has to take. Which can be diagnosed in the above few ways.
The level of mixed leverage can be used to measure the percentage of earnings per share that changes with the percentage of a firm’s sales.
For example, Shubh & Co.’s management leverage level is 3 and financial leverage level is 4. In this case, the level of mixed leverage will be (3×4) = 12.
Therefore, if the sales change by 1 percent, the earnings per share of the leverage will change by 12 percent. So it can be said that its effects are twofold.
For example, when sales increase, the effect is favorable and when sales decrease, the effect is unfavorable.
This leverage is also used to make investment decisions when choosing the right option from the financial planning option.
The effect of matte leverage in the real sense is that if a firm invests in a high-risk project or asset, its operating leverage will increase. Which basically increases the total kick of the firm. In this case, Hati will work to reduce financial leverage so that additional operating risks can be met.
In the beginning – the firm will be able to adopt a financial plan with more financial leverage if there is early leverage management. The main reason for this is that it will stabilize the firm’s mature risk and increase the share income by changing the sales.
At the end of the discussion, it can be said that a financial manager is always trying to figure out how to grow. If the mate’s share price rises, the firm’s financing system can be kept smooth and smooth, or it can try to determine the level of mixed leverage as expected with the mate’s look. Earnings per share can be maximized.
Are You Clear this question. Discuss the effects of Total leverage.
Finally Lots of thanks for reading this content of Financial Leverage. If anything Don’t understand please comment on us. We are ready to give an answer.