Question

What is leverage and what are two major types of leverage? Define each.

Answer 1

Leverage is stated as the borrowing of debt and funds in order to the finance the purchase of equipment, inventory and other assets. The owner of a company can use either debt or equity to finance assets. Use of debt leverage might let company to go bankrupt.

There are two types of leverage namely:

1)Operating leverage - operating leverage may be stated as the percentage of a company's fixed cost. in another word, if a firm is experiencing the higher amount of fixed cost in comparison with variable cost then the firm will have high operating leverage.

The formula of operating leverage:

Operating leverage = contribution margin/net operating income

2)Financing leverage - Financial leverage nay be stated as presence of debt in the capital structure of the company. If the financing of a firm's assets is done by raising debt then the firm will experience the high level of risk and it can lead the firm's return on equity and earning per shares to go up as the firm is not diluting the stockholder's earnings by using the equity shares financing.

The formula of financial leverage is shown below:

Financial leverage = Earnings before interest and tax/Earnings before tax