Leverage: Concept and Significance
Leverage, as a business term, refers to debt or to borrowing funds to finance the purchase of inventory, equipment and other company assets. Business owners can use either debt or equity to finance or buy the company’s assets. Using debt, or leverage, increases the company’s risk of bankruptcy – but, it also can increase the company’s profits and returns; specifically its return on equity. This is true because if debt financing is used rather than equity financing then the owner’s equity is not diluted by issuing more shares of stock.
Borrowing in order to expand or invest is called leverage because the goal is to amplify the loan into a greater value for the firm or investors.
With debt financing, regardless if whether the interest charges are from a loan or line of credit, the interest payments are tax deductible. In addition, by making timely payments a company will establish a positive payment history and business credit rating.
Investors in a business prefer the business to use debt financing but only up to a point. Beyond a certain point, investors get nervous about too much debt financing as it drives up the company’s default risk.
Significance of Leverage
Leverage refers to the use of fixed costs in an attempt to increase the profitability. Leverage affects the level and variability of the firm’s after tax earnings and hence, the firm’s overall risk and return. The study of leverage is significant due to the following reasons.
(I) Measurement of Operating Risk
Operating risk refers to the risk of the firm not being able to cover its fixed operating costs. Since operating leverage depends on fixed operating costs, larger fixed operating costs indicates higher degree of operating leverage and thus, higher operating risk of the firm. High operating leverage is good when sales are rising but bad when they are falling.
(II) Measurement of Financial Risk
Financial risk refers to the risk of the firm not being able to cover its fixed financial costs. Since financial leverage depends on fixed financial cost, high fixed financial costs indicates higher degree of operating leverage and thus, high financial risk. High financial leverage is good when operating profit is rising and bad when it is falling.
(III) Managing Risk
Relationship between operating leverage and financial leverage is multiplicative rather than additive. Operating leverage and financial leverage can be combined in a number of different ways to obtain a desirable degree of total leverage and level of total firm risk.
(IV) Designing Appropriate Capital Structure Mix
To design an appropriate capital structure mix or financial plan, the amount of EBIT under various financial plans, should be related to earning per share. One widely used means of examining the effect of leverage to analyze the relationship between EBIT and earning per share.
(v) Increase Profitability
Leverage is an effort or attempt by which a firm tries to show high result or more benefit by using fixed costs assets and fixed return sources of capital. It insures maximum utilization of capital and fixed assets in order to increase the profitability of a firm, It helps to know the reasons not having more profit by a company.