Definition of leverage
What is leverage in finance?
Leverage in finance is using borrowed funds to amplify potential returns or losses from an investment. It involves borrowing money to invest, to generate higher returns than the cost of borrowing.
It can magnify gains, but it can also magnify losses if investments do not perform as expected. It can be used in various financial markets, including stocks, real estate, and forex trading.
A good example of leverage
Let’s consider the scenario where company Z wants to acquire a $500,000 asset with the option to finance it through either equity or debt. If the corporation opts for equity financing, it’ll own the asset outright and will not be liable for interest payments.
If the asset’s value increases by 50%, its worth will be $550,000, resulting in a profit of $50,000 for the corporation. Conversely, if the asset’s value drops by 50%, it will be valued at $450,000, resulting in a loss of $50,000.
Alternatively, the corporation may finance the asset using a 50/50 blend of common stock and debt. If the asset’s value increases by 50%, it’ll be valued at $550,000.
Why is it important?
- It increases the potential returns for an investment
- It also helps investors to increase their purchasing power
- Help investors to diversify their portfolios
- Sometimes, the interest paid on borrowed funds can be tax deductible, reducing the overall tax liability for investors.
Methods to calculate leverage?
There are various leverage financial ratios to calculate leverage.
The main method is using debt-to-equity ratio. The ratio indicates the proportion of debt to equity in a company and measures firms’ level of financial leverage. It helps to determine risk level in company capital structure.
Here is the formula:
Debt/Equity Ratio = Total Debt/ Total Equity
Other financial leverage ratios to evaluate financial risks include:
- Debt-to-asset ratio
- Debt-to-EDITDA ratio
- Interest coverage ratio
What are the 3 types of leverage in financial management?
There are three types of leverage in financial management. Let’s explore them.
1. Financial Leverage in financial management
Financial leverage is whereby a firm uses its funds of fixed financial charges to attain the effects of variation in EBIT on EPS. There is fixed financial charges and non-fixed financial charges.
Fixed financial costs include bonds, preference shares, long-term loans, and debentures, while non-fixed financial charges include equity shares.
It relates to a firm’s capital structure’s mix of debt and equity. It results from fixed financial charges from the company’s income stream.
How to compute financial leverage
The degree of financial leverage is the percentage variation in earnings per share to percentage variations in earnings before taxes and interest. Thus, expresses FL in terms of quantitative. The higher the fixed charge in a firm’s capital structure, the higher the DFL.
Therefore;
Financial Leverage = (Operating Income /EBIT)/(Taxable Income/EBT)
EBIT/(EBIT-I) = EBIT/EBT.
Whereas;
(i) EBT is Earnings before Tax.
(ii) EBIT is Earnings before Tax and Interest
(iii) And “I” is an interest.
Degree of Financial Leverage = (EPS Percentage change)/(EBIT Percentage change)
Benefits of financial leverage
There are several benefits of finance leverage. These include:
- A high FL level implies high fixed costs of financial and risk
- It helps to determine the debt amount in the capital structure of a company
- Aids to balance financial return and risk in capital structure
- It helps financial managers to develop an optimal capital structure
- Shows return on investment (ROI) excess over fixed costs using funds
2. Operating Leverage in financial management
It is whereby a company uses its fixed operating cost to increase its returns.
Operating costs are of three types:
- Fixed
- Semi-variable
- Semi-fixed.
Unlike semi-variable and semi-fixed costs, fixed cost does not change. It relates to changes in sales and profit.
How to compute operating leverage
You get it by computing the Degree of Operating Leverage (DOL). The DOL is the percentage change in firms’ earnings before interest and taxes. DOL analyses operating leverage in terms of quantitative.
The DOL should have a value greater than one. That said, the higher the fixed operating cost, the higher the degree of leverage.
Therefore;
Operating leverage = Contribution/ (Operating Profit)
Degree of Operating = (EBIT Percentage change)/ (Percentage change in sales).
Benefits of operating leverage
- Higher operating leverage shows more sales are needed to attain a break-even point
- Higher operating leverage indicates a low margin of safety, while low operating leverage shows a high margin of safety
- A high level of operating leverage indicates high operating profit
- The higher DOL suggests the effects of changes in sales volume
3. Combined Leverage in financial management
It refers to the combined effect of operating and financial leverage on a company’s earnings before interest and taxes (EBIT). Operating leverage refers to the relationship between fixed and variable costs, while financial leverage relates to using borrowed funds to finance operations.
That said, combined leverage considers the impact of changes in sales on a company’s EBIT, considering both fixed and variable costs plus the cost of borrowed funds. Understanding it helps companies make informed decisions about their capital structure and financial risk management.
How to compute combined leverage
To compute, you need to know the DOL and the DFL.
DOL measures the change in EBIT resulting from a change in sales. It is calculated as follows:
DOL = (Sales – Variable Costs) / EBIT
DFL measures the earnings per share (EPS) change resulting from a change in EBIT. You calculate it as follows:
DFL = EBIT / (EBIT – Interest Expense)
Once you have calculated the DOL and DFL, you can compute the degree of combined leverage (DCL) as follows:
DCL = DOL x DFL
The DCL measures the change in EPS resulting from a change in sales, taking into account both operating and financial leverage. A higher DCL shows a greater sensitivity of EPS to changes in sales, and therefore greater financial risk.
Benefits of combined leverage
- It helps companies understand the impact of changes in sales on their earnings and identify potential financial risks
- It provides a more comprehensive view of a company’s financial performance, enabling better decision-making
- It helps in identifying the optimal mix of debt and equity financing, thus increase efficiency and reduce their cost of capital
- By analyzing the impact of changes in sales on earnings, companies can better predict future cash flows and earnings
- In addition, it provides a common language for financial professionals to discuss a company’s financial performance
Pros
- Generate higher returns
- Increased buying power
- Diversification opportunities
- Tax benefits
- Flexibility
Cons
- Magnified losses
- Increased risk
- Incurs interest costs
- Margin calls
- Limited availability
Leverage vs Margin
Leverage and margin are two concepts used interchangeably in finance, but they have distinct meanings. Leverage refers to the use of borrowed funds to amplify potential returns or losses from an investment. Margin refers to the amount of collateral required to support an investment made with borrowed funds.
Leverage is the concept of using debt to finance investments. While margin is the amount of equity required to secure a loan for investment.
While they are related, it’s important to understand the differences between these two concepts to effectively manage investment risk.
The bottom line
So, what is Leverage? In finance, it’s using borrowed money to increase your potential profits. When used correctly, it is a powerful tool for investors and traders.
It can be operating, financial, or combined. There are many benefits to leveraging your portfolio – from increased returns to reduced risk.
But don’t forget that there is no such thing as a free lunch in investing. Make sure you’re aware of the risks before diving in!