Introduction
Leverage refers to the strategic use of assets or funds to enhance returns. It magnifies the impact of changes in sales or operational performance on profitability. While leverage can boost returns, it also increases risk, creating a direct risk–return relationship: higher leverage typically leads to higher risk and, potentially, higher returns.
Key Characteristics of Leverage
1. Leverage applies to the use of assets or funds to generate returns.
2. Profits tend to change at a faster rate than sales.
3. The risk–return relationship generally moves in the same direction.
4. Higher leverage results in higher risk and higher expected returns.
Types of Leverage
1. Return on Investment (ROI) Leverage
An index of operational efficiency.
Formula: ROI Leverage = EBIT / Total Assets
2. Asset Leverage
A component of ROI leverage, similar to asset turnover.
Formula: Asset Leverage = Sales / Total Assets
A higher turnover indicates a higher degree of asset leverage.
3. Operating Leverage
Relates to fixed operating costs.
Measures the impact of sales changes on operating income.
Formula: Operating Leverage = Contribution / EBIT
4. Financial Leverage
Depends on the proportion of debt and preferred stock in relation to common equity.
Measures the effect of fixed financial costs.
Formula: Financial Leverage = EBIT / EBT
5. Combined (Composite) Leverage
Captures the joint effect of operating and financial leverage on taxable profits.
Formula: Composite Leverage = Operating Leverage × Financial Leverage
Or: Composite Leverage = Contribution / EBT
Behaviour of Operating Leverage
The Degree of Operating Leverage (DOL) quantifies the sensitivity of operating income to changes in sales:
DOL = (% Change in EBIT) / (% Change in Sales)
Key Points:
– A high DOL means that a small change in sales will produce a large change in operating income.
– DOL is particularly useful in:
1. Capital Budgeting – originally developed for evaluating investment projects.
2. Long-Term Profit Planning – by assessing the scale of fixed cost investments and their potential impact.
3. Risk Assessment – as high operating leverage increases a firm’s business risk.
In capital structure decisions, firms with high operating leverage must carefully evaluate the additional risk from financial leverage before increasing debt levels.
Degree of Combined Leverage (DCL)
The Degree of Combined Leverage measures the total effect of operating and financial leverage on earnings per share (EPS):
DCL = (% Change in EPS) / (% Change in Sales Volume)
A high DCL indicates that the company’s EPS is highly sensitive to changes in sales, amplifying both potential gains and potential losses.
Conclusion
Understanding operating, financial, and combined leverage is crucial for effective financial management. While leverage can enhance profitability, it also increases the risk profile of a business. Managers must balance the desire for higher returns with the need to maintain acceptable levels of financial and operational risk.
