What is Leverage Explained?

What is the concept of leverage? How many types of leverage is there? What kind of companies or business are high in operating leverage? What is the leverage calculation formula? Which type of businesses are low in operating leverage? What is the meaning of high financial leverage company and low financial leverage company? How is leverage ratio calculated?

When we talk about the concept of leverage, so its concept originates from science. If I tell you in simple language, leverage is such a tool, which makes our work easier. This means when we talk about higher leverage or when we increase lever That means we have to put less effort and we get more output. So when we apply the same concept in finance, so first is operating leverage cause of the cost structure and second is financial leverage cause of capital structure. Now, the operating leverage is a fixed cost For any business which has a high fixed cost, we’ll say that the company has high operating leverage. Similarly In any financial leverage your debt or loan is your financial leverage. So if a company has taken a big loan so that means they are using someone else’s money. They have to put in less effort and they might get more output so that is the degree of financial leverage. High operating leverage definitely has benefits, as well as drawbacks and Higher financial leverage has benefits and drawbacks

What effects do high operating and financial leverage have on sales and profit?

the ‘l’ lever is increased So when there is lower leverarge, it means you have to put in more efforts you’ll have to apply more force to lift the weight. Now that you have increased the leverage, the force you have to apply here is less. It may be that you have to apply F/2 force instead of F and it’s also possible that you might lift more weight I am not going into exact formula that exactly how much weight you’ll get to lift or the exact force you’ll have to apply. Mainly we want to understand that in lower leverage we have to put in more effort and the output gained is less and when we increase leverage, we have to put in less effort and we get more output from it. Now the same concept is applicable in finance.

Types of Leverage?

  • So one we have our operating leverage operating leverage depends on what kind of cost structure the company has.
  • Second is the financial leverage it depends on how the company has used its capital structure what portion of it is the debt or loan that have taken and what portion they have used their equity capital. So the lever in the operating leverage, and the leverage we’re talking about here that is our fixed cost. So if the fixed cost is high in any company or industry that means we say it’s opertaing leverage is high. The lever in the financial leverage that is basically our debt, which means the loan that how much loan has the company taken So the higher your debt or loan is, the higher your financial leverage will be.

how are these high operating leverage companies?

Now let’s understand the concept in detail. So how are these high operating leverage companies?

High operating leverage companies

We take the example of the Airlines industry Fixed costs are very high in it Let’s see what are the fixed cost. The company can either purchase the aircraft or take it on the lease, it’s a fixed cost. So money is definitely spent on it each month whether the passengers come or not. Now the hangar, where the airplane is held, there will be some lease of it, it’s also a fixed cost. Company would have insured the airplanes, so it’s a fixed cost. So the fixed costs are very high in the Airlines industry. What are variable costs? Like jet fuel, if the plane does not fly, fuel won’t be used, there will be no runway charge. So these are variable costs. So the fixed costs are very high in the Airlines industry. So when the fixed cost gets high, we say that operating leverage of the company has increased. So in the calculation, we calculate the degree of operating leverage. If the degree of operating leverage is two times, what does that mean? It means if sales increase by 20% then the operating profit increases by 40%, but it’s a double-edged sword if the sales in it become -20% then your operating profit will be -40%. So here, if the operations are going well, it’s a very good thing. So these kind of companies do very well if the market is good. If by chance there is a recession, then there is high operational risk. If sales drop even a little then operational profit starts to decrease drastically.

Low operating leverage companies

On the other side if we talk about low operating leverage companies, in it, the degree of operating leverage is quite low. For example, there is a consulting or service industry, what are the fixed costs in it? Wherever company has opened the office, its rent, Electricity bill, water bill, all the fixed bills like these. Variable costs are high for these, mainly salaries. So the salaries of the people working there are the main cost. So these kind of companies increase or decrease their workforce depending on the market condition. So here the flexibility is high. So that’s why, when we say our degree of operating leverage is high, which means the operational risk of these companies is high. So we talked about operating leverage here.

Financial Leverage

 Now, let’s talk about financial leverage. When we say a company is a high financial leverage company, so let’s say in real estate, companies have to take a lot of debt. Assume we have to make a building and rent it, people do not prefer to use their own money, they prefer to use bank’s money, so their returns can get better. So what happens in it? If your Return on Investment is greater than whatever the interest you’ve taken from the bank, then the company can grow rapidly. For example. if the return on investment comes to be 20% In a real estate company, let’s say rent is very good from a particular location and the company is getting a great total return on investment, and it has to give only 12% interest. So this net +8%, company is earning it from outside only. It’s using bank’s money at 12% and is earning 8% from outside. But in bad market conditions, it can be the opposite, because it definitely has to give 12% interest to the bank. So if the return on investment falls below the interest, then company can go bankrupt, it can fold up very fast. Let’s say the return on investment is 6% but interest is still 12 %, then this -6% difference, promotors or company will have to give from their own coffers or wallet. That’s why high financial leverage companies grow very fast in good market conditions.

If market conditions are bad, that can be very dangerous and it might cause bankruptcy for the company. In today’s date, a lot of real estates companies are about to be bankrupt and its main reason is that their debt has increased a lot. That’s why high financial leverage companied have high solvency risk. It got hidden here. Basically, I’m talking about solvency risk and bankruptcy. So chance of bankruptcy increases if market conditions are bad. Now let’s talk about low operating leverage companies.

Low Operating Leverage

In low operating leverage company, you can take example of software industry. Software industry is also a service industry. In it, you don’t need to take a lot of debt. people take only working capital loan sometimes. So basically the loan is zero or very low. We can call it negligible relative to company turnover. So even if the return on investment decreases generally return on investment does not decrease in service industry, but by chance even if it decreases Assume a product company. Let’s say it makes a product, its initial costs turn out to be high, because it hasn’t taken a loan, even if the return on investment is low, it will survive. Let’s say the return on investment is only 6% even then it’ll survive, but here the company which has high debt, it won’t be able to survive because it’s paying 12% interest. That’s why solvency risk is less of low operating leverage companies. So we’ve understood the basic concept of operating and financial leverage.

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