If you are new at stocks and tradings, you may have come across the term “leverage“. Well, in the following article we clear all your doubts related to the meaning of leverage and the three types of leverage such as financial leverage, operating leverage, combined leverage.
Meaning of Leverage:-
Leverage is a business term which usually refers to the debt taken by a company to fund its operations and expansion projects in an effort to generate a return for shareholders. The term also refers to the use of a significant amount of debt to purchase an asset, operate a company, acquire another company and many more.
Usually, the cost of borrowed money is quite lesser than the cost of obtaining additional stockholders’ equity. As a result, it is usually it is always a wise decision for a corporation to use some debt and leverage. And that is why leverage is also known as trading on equity.
Different types of leverage
There are usually three types of leverage, such as Operating Leverage, Financial Leverage, Combined Leverage. And now, let’s discuss them one by one.
1. What is Operating Leverage
Operating leverage is a term uses to show the percentage of fixed costs that a company has. And the fixed operating costs of a company are depreciation, insurance of assets, repairs and maintenance, property taxes etc. If the proportion of the fixed operating cost is higher than the variable cost, the operating leverage will be also higher. So, if a firm has high operating leverage, a small change in sales volume effects in a large change in EBIT and ROIC (Return on Investment Capital). In other words, companies with high operating leverage are very delicate to changes in sales and it affects their bottom line rapidly.
2. What is Financial Leverage
The term refers to the amount of debt a company has in the capital structure. Financial Leverage generally deals with profit magnification. Financial leverage always helps the financial manager to design an ideal capital structure. The optimum capital structure indicates that the combination of debt and equity at which the overall cost of capital is minimum. But, the value of the firm is maximum. Moreover, high financial leverage symbolises the existence of high financial fixed costs as well as high financial risks. As a result, it brings a balance between financial risk and returns in the capital structure.
3. Combined Leverage
Combined leverage indicates the total amount of risk a company is facing. As a result, it shows the combined effect of operating leverage and financial leverage. It is the total amount of leverage that we can use to amplify the returns from our business. Whereas, Operating leverage amplifies the returns from our plant and fixed assets and Financial leverage magnifies the returns from our debt financing. Combined leverage is the total of these two above mentioned leverage.
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