FINANCIAL DECISION : LEVERAGE

Leverage in Financial Analysis

Leverage in financial analysis refers to the effect of a change in one financial variable (such as sales) on another (such as earnings). It measures sensitivity and risk-return trade-offs in business decisions.

Common variables affected by leverage include:

Costs
Output
Sales Revenue
Earnings Before Interest and Taxes (EBIT)
Earnings Per Share (EPS)

When we calculate how much one variable (Y) changes in response to another variable (X), we are measuring leverage of Y with respect to X.

Leverage Formula:
Leverage = (% Change in Y) / (% Change in X)

Types of Leverage

1. Operating Leverage

Operating leverage refers to the degree to which a company uses fixed operating costs. Higher operating leverage means higher potential gains and risks from changes in sales.

Degree of Operating Leverage (DOL) = % Change in EBIT / % Change in Sales

Example: If sales increase by 10% and EBIT increases by 25%, DOL = 25% / 10% = 2.5

2. Financial Leverage

Financial leverage arises from the use of fixed-cost financial instruments (like debt). It measures how sensitive EPS is to changes in EBIT.

Degree of Financial Leverage (DFL) = % Change in EPS / % Change in EBIT

Example: If EBIT increases by 20% and EPS increases by 40%, DFL = 40% / 20% = 2

3. Combined Leverage

Combined leverage takes both operating and financial leverage into account. It shows the sensitivity of EPS to changes in sales.

Degree of Combined Leverage (DCL) = % Change in EPS / % Change in Sales
or DCL = DOL × DFL

Example: If DOL is 2.5 and DFL is 2, then DCL = 2.5 × 2 = 5

Implications of High Leverage

Higher leverage magnifies both profits and losses.
It increases the volatility of returns for shareholders.
Highly leveraged firms face greater financial risk during downturns.
Balanced leverage helps in optimizing returns with manageable risk.

Conclusion

Leverage is a powerful financial tool used by businesses to magnify potential returns. However, it must be used with caution, as it also amplifies the risk. A careful analysis of operating and financial leverage is crucial for strategic financial planning and risk management.