Leverage Effect on ROE

>> March 7, 2011


Before writing leverage effect on return on equity (ROE), I have read my old content leverage and its type which I wrote more than one year ago. But, this content gave me idea to explain the leverage effect on ROE more clearly. If you are new for learning leverage, we are introducing it first.  Leverage means lifting machine. In lifting machine, what do you see? A person uplifts the weight with the help of machine. Even uplifted weight may be 1000 times heavy than that person's own weight.  But in this finance term, it is not lifting machine. but like lifting machine, we can use leverage tool to uplift return on equity level.

What is ROE?

Before analysing, leverage effect, we should know what is return on equity?  Return on equity is that rate of return on equity share capital. It is also called shareholder return. ROE can be seen with two way. From company point of view, it is return on his investment which company has to raise at any cost for surviving the business but from shareholder point of view, it is dividend. ROE shows the efficiency of company. If company generated high ROE, it is good for company and its shareholders. ROE can be changed by changing the leverage. Now we study the effect of leverage on ROE.

What are Sources of Leverage?

a) Taking Loan

b) Taking fixed asset

c) Taking Hedge fund

Leverage Effect on ROE

If we talk the leverage effect on ROE, it means, we talking operating leverage effect, financial leverage effect and combined leverage effect on ROE.

1. Operating Leverage Effect : % Change of EBIT is more than % Change in Sale

If % change of  earning before interest and tax is more than % change in sale, this operating leverage will effect ROE positively because at this level, per unit fixed cost will decrease and small increase in sale will boost EBIT. If EBIT will increase, ROE will also increase. After dividing % Change of EBIT with % changes in sales. We can take ratio of it and it indicates, how will change EBIT if changes will be done in sales. 2:1 of operating leverage means if 100% sales will increase 200% EBIT will increase. As interest is fixed cost, so with this ROE will increase.

A Situation : High  Operating Leverage :

 Too high operating leverage is not good, it may be high risky.

B Situation : Low Operating Leverage  :

Low operating leverage may be useful when sale market is fluctuating.

2. Operating Leverage Effect : % Change of EBIT is less than % Change in Sale

Now see also second face when % changes of EBIT is less than % changes in sales, it means 200% sale will increase, 100% EBIT will increase if operating leverage is 1:2. This situation is less effective for enhancing ROE.

3. Effect of Financial Leverage on ROE 

If we have to check real effect of leverage on ROE, we have to study financial leverage. Financial leverage refers to the use of debt to acquire additional assets. Financial leverage may decrease or increase return on equity in different conditions.

A Situation : High Financial Leverage :

Financial over-leveraging means incurring a huge debt by borrowing funds at a lower rate of interest and utilizing the excess funds in high risk investments in order to maximize returns.
B Situation : Low Financial Leverage :

Financial low-leveraging means incurring a low debt by borrowing funds. It may effect positively, if decrease the value of  bought asset with this low debt.

4. Effect of High Operating leverage and High Financial Leverage

It will increase ROE but it is high risky also.

5. Effect of Low Operating leverage and High Financial Leverage

It is optimum combination for bringing optimum return on equity.

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