Levereges and its types
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This document discusses three types of leverage: operating, financial, and combined. Operating leverage is defined as the percentage change in earnings before interest and taxes (EBIT) divided by the percentage change in sales. Financial leverage is defined as the percentage change in earnings per share (EPS) divided by the percentage change in EBIT. Combined leverage is the product of operating leverage and financial leverage, and represents the overall financial risk of a company. The document provides formulas for calculating each type of leverage and notes that high operating leverage combined with high financial leverage poses the greatest risk.
Levereges and its types
- 1. Prepared by: SHIFAS IBRAHIM S2 MBA B BATCH
- 3. 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 .
- 4. Main aim of leverage testing is maximize the earning of shareholder and reduce the risk of company. Different types of leverage: operating leverage financial leverage combined leverage
- 5. operating leverage 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 . Formula 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 .
- 6. 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 .
- 7. 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.