Type of leverage:
Company's finance manager tests three types of leverages:
A. Operating leverage is the percentage change in earnings prior to interest and tax divided by percentage change in the sale. When company is charging fixed cost, the operating leverage states the EBIT will more than sale since due to rising sale of fixed cost per unit will reduce and it will raise EBIT more than sale.
Operating Leverage = Percentage change in EBIT / Percentage change in Sale
This leverage is very obliging for finance manager since, if operating leverage is greater than or assume it is two then it means when sale will raise 100% then earning will raise 200%. At this time, finance manager can obtain additional loan for rising the earning of shareholders. B. Financial leverage: It is the second kind of leverage. Financial leverage is termed as trading on equity. When any company's finance manager recognizes that company's return on investment is greater than interest on loan or borrowing obligation. At this time, whenever company requires additional money, then finance manager acquires its loan and bought the asset from similar loan. Therefore, any method in which any asset is purchased with loan and trying to raise EPS, then this is termed as financial leverage.
Formula for computing financial leverage:
= Percentage change in Earning per share / Percentage change in earnings before interest and tax = % change in EPS / % change in EBIT
This formula describes the relationship between % change in EPS and % change in EBIT and subsequent to deep study of this financial leverage, finance manager judges to get suitable loan for buying assets.
C. Combined leverage:
This is the product of operating leverage and financial leverage.
Combined leverage = Operating leverage X financial leverage
= % change in EBIT / % change in sale X % change in EPS / % change in EBIT
→ High operating and high financial leverage combination is much high risky for business.→ Excellent combination is that in which lower operating with high financial leverage.
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