Leverage and its types

Leverage is very scientific tool in the hand of finance manager . Finance manager uses this tool for making effective financial structure of company . Financial structure is just mix of debt and equity and with help of leverage , finance manager gets fund with effective ratio of debt and equity .

In simple word leverage is power and relationship between two interrelated variables . These variables may be output , sale , cost and profit . Finance manager calculates these leverage by apply formula and then uses them for taking decision in favour of company's shareholder . Main aim of leverage testing is maximize the earning of shareholder and reduce the risk of company.

Type of leverage :-

Company's finance manager tests three type leverage :-

1. Operating leverage is % change in earning before interest and tax divided by % change in sale . If company is charging fixed cost , the operating leverage tells the EBIT will greater than sale because due to increasing sale of fixed cost per unit will decrease and it will increase EBIT higher than sale .


Operating Leverage = % change in EBIT / % change in Sale

This leverage is very helpful for finance manager because , if operating leverage is more than or suppose it is two then it means if sale will increase 100% then earning will increase 200% . At this time , finance manager can get more loan for increasing the earning of shareholders .

2. Financial leverage

It is second type of leverage . Financial leverage is known as trading on equity . If any company's finance manager knows that company's return on investment is more than interest on loan or borrowing obligation . At this time , if company needs more money , then finance manager gets its loan and bought the asset from same loan . So, any technique in which any asset is purchased with loan and trying to increase EPS , then this is called financial leverage .

Formula for calculating financial leverage

= % change in Earning per share / % change in earning before interest and tax

= % change in EPS / % change in EBIT

This formula explains the relationship between % change in EPS and % change in EBIT and after deep study of this financial leverage , finance manager decides to get appropriate loan for buying assets .

3. Combined leverage

It is the product of operating leverage and financial leverage .

Combined leverage = Operating leverage X financial leverage

= % change in EBIT / % change in sale X % change in EPS / % change in EBIT

→ High operating leverage and high financial leverage combination is high risky for business .
→ Good combination is that in which lower operating leverage with high financial leverage .


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Accounting Education: Leverage and its types
Leverage and its types
Accounting Education
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