Question

What is term leverage? What are the Positive and Negative aspect of Finical leverage, Operating leverage & Total leverage ?

Answer 1

Leverage refers to fixed cost or use of fixed cost funds used in business. If Fund uses fixed cost funds to fund its operations, it can be called leveraged.

1.Operating leverage means use of asset with fixed cost to cover variable and fixed expenses and generate profit. If company has fixed costs, usually operating leverage comes into picture. Greater the fixed cost, higher would be operating leverage and vice versa.

Positive aspects of operating leverage

Higher operating leverage ensure that profit increases at higher rate as compare to change in sales.

Negative aspects of operating leverage

Higher operating leverage may affect firm's cash liquidity in future if revenue forecast is done incorrectly.

2. Financial leverage is degree of use of debt used in capital of the firm. Due to use of fixed cost loans or debts issued, company incurs additional charge and profit is affected. Hence higher the debt component, higher would be degree of financial leverage.

Positive aspects

Interest expense is deductible for tax purposes.

Negative aspects

Higher break even point

Risk of bankruptcy

3. Total leverage is combination of operating and financial leverage. It establishes relationship between revenue and earnings per share. It can be calculated as degree of operating leverage* degree of financial leverage

Positive aspects

Higher growth due to higher funds

Tax benefits

Negative aspects

Increased risk of defaults in payment obligations

Cash liquidity crisis