Leverage is a practice that can help a business drive up its gains/losses. In business language, if a firm has fixed expenses in the 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 introducing expenses that 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 business’s activity. For example, an amount of investment made in fixed assets or interest paid on loans does not change with a normal change in the number of sales. Neither do they decrease with a decrease in sales, nor do they increase with an increase in sales.
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 fixed financial expenses such as interest and dividends on preference shares. Like them, leverages are also of two types – financial and operating.
Financial Leverage (FL)
A Degree of Financial Leverage is created with the help of the debt component in a company’s capital structure. The higher the debt, the higher would be the FL because with higher debt comes a higher amount of interest that needs to be paid. It can be good and bad for a business depending on the situation. If a firm can generate a higher return on investment (ROI) than the interest rate it is paying, leverage will have a positive effect on shareholder return. The darker side is that if the said situation is the opposite, higher leverage can take a business to the worst case, like bankruptcy.
Operating Leverage (OL)
Just like the financial, it is a result of operating fixed expenses. The higher the fixed expense, the higher is the Operating Leverage. 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). Under good economic conditions, an increase of 1% in sales will have more than a 1% change in operating profits.
So, you need to be very careful in adding any leverages to your business. And these are financial or operating, as it can also work as a double-edged sword.
Combined or Total Leverage is a combination of both operating and financial leverage.
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, and the operating profits can see a sharp increase with a slight 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, the higher the degree of leverage, the higher will be the percentage increase in operating profits and earnings per share.
Disadvantages of Higher Leverage
It 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 a no loss / no-profit situation. Financial leverage increases the minimum requirement of operating profits to meet interest expenses. If the activity level is not attained, 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 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.
Read more about Financial Leverage.