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Mahesh Kumar Sarva, Lovely Professional University Unit 7: Concept of Leverages

Unit 7: Concept of Leverages Notes

CONTENTS
Objectives
Introduction

7.1 Operating Leverage
7.2 Relation with Break-even Analysis
7.2.1 Changing Costs and the Operating Break-even Point

7.2.2 Fixed Cost and Operating Leverage
7.3 Financial Leverage
7.4 Combined Leverage
7.5 Summary
7.6 Keywords

7.7 Review Questions
7.8 Further Readings

Objectives

After studying this unit, you will be able to:

 Describe the notion of leverage;
 Define the operating leverage;
 Explain the significance of financial leverage;
 Discuss the aspect of combined leverage.

Introduction

Leverage results from the use of fixed costs assets or funds to magnify returns to the firm’s
owners. Generally, increases in leverage results in increased returns and risk; and decreases in
leverage results in decrease in returns and risk. The amount of leverage in the firm’s capital
structure (the mix of long-term debt and equity) can significantly affect its value by affecting
returns and risks.
The term ‘leverage’ in general refers to a relationship between two interrelated variable. In
financial analysis, it represents the influence of one financial variable over some other related
financial variable.
The three basic types of leverage can be defined with reference to firm’s income statement as
follows:
1. Operating leverage is concerned with the relationship between the firm’s sales revenue
and its earnings before interest and taxes, or EBIT (EBIT is descriptive label for operating
profits).
2. Financial leverage is concerned with the relationship between the firms EBIT and its
common share earnings per share (EPS earnings per share). It is defined as the firm’s

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