Leverage is a practice which can help a business drive up its gains / losses. In business language, if a firm has fixed expenses in P/L account or debt in capital structure, the firm is said to be levered. Nowadays, almost no business is away from it but very few have struck a balance.
In finance, leverage is very closely related to fixed expenses. We can safely state that by the introduction of expenses which are fixed in nature, we are leveraging a firm. By fixed expenses, we refer to the expenses, the amount of which remains unchanged irrespective of the activity of the business. For example, an amount of investment made in fixed assets or interest paid on loans does not change with a normal change in a number of sales. Neither they decrease with a decrease in sales and nor they increase with an increase in sales.
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Types of Leverage
There is a different basis for classifying business expenses. For our convenience, let us classify fixed expenses into operating fixed expenses such as depreciation on fixed expenses, salaries etc, and financial fixed expenses such as interest and dividend on preference shares. Similar to them, leverages are also of two types – financial and operating.
Financial Leverage (FL)
It is a leverage created with the help of debt component in the capital structure of a company. Higher the debt, higher would be the FL because with higher debt comes the higher amount of interest that needs to be paid. It can be both good and bad for a business depending on the situation. If a firm is able to generate a higher return on investment (ROI) than the interest rate it is paying, leverage will have its positive effect shareholder’s return. The darker side is that if the said situation is opposite, higher leverage can take a business to a worst situation like bankruptcy.
Operating Leverage (OL)
Just like the financial, it is a result of operating fixed expenses. Higher the fixed expense, higher is the OL. Like the FL had an impact on the shareholder’s return or say earnings per share, OL directly impacts the operating profits (Profits before Interest and Taxes (PBIT)). Under good economic conditions, an increase of 1% in sales will have more than 1% change in operating profits.
So, you need to be very careful in adding any of the leverages to your business viz. financial or operating as it can also work as a double edged sword.
Advantages and Disadvantages of Leverage
In totality, it has its advantages under good economic situations and at the same time, it is not free from disadvantages.
Advantages of Higher Leverage
Take OL, the operating profits can see a sharp increase with a small change in sales as most parts of the expenses are stagnant and cannot further increase with sales.
Likewise, if we consider FL, the earnings share of each shareholder will increase significantly with an increase in operating profits. Here, higher the degree of leverage, higher will be the percentage increase in operating profits and earnings per share.
Disadvantages of Higher Leverage
Leverage inherits the risk of bankruptcy along with it. In the case of operating leverage, fixed expenses extend the break-even point for a business. Break even means the minimum activity (sales) required for achieving no loss / no profit situation. Financial leverage increases the minimum requirement of operating profits to meet with the expense of interest. In any case, if the required activity level not achieved, bankruptcy or cash losses become certain.
Looking at the pros and cons, it seems that a balance is required between the rewards and risks. The degree of leverage should not be too high which invites the bankruptcy and on the contrary, it should not be too low that we lose out on the benefits and the viability of a business itself comes under question.Last updated on : August 31st, 2017