Leverage can be defined as “the employment of an asset or source of funds for which the firm has to pay a fixed cost or fixed return”. Because of the incurrence of fixed costs, the net income and the earnings available to the equity shareholders as well as the risk gets affected. Leverage is favourable when the earnings less the variable costs exceed the fixed costs or when the earnings before interest and taxes exceed the fixed return requirement. Leverage is unfavourable in the reverse situation.
Leverage can be of two types – Operating & Financial leverages.
Operating leverage
Operating leverage is the ratio that shows the between contribution (sales revenue less variable cost) and earnings before interest and tax or EBIT.
This ratio gives an idea about the presence of fixed cost and its volume as compared to the variable cost used in the business as depicted above.
Financial Leverage
Financial leverage is the ratio that shows relationship between earnings before interest and tax (EBIT) and earnings before tax (EBT).
This ratio gives an idea about the presence of loans and its volume as compared to equity capital in the business.
Combined leverage
This is the product of the operating and financial leverages.
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