Question

Why is Total Leverage the ultimate measurement that an entrepreneur would follow?

Answer 1

Leverage in common parlance refers to the use of debt financing for purchase of assets (mostly fixed) for business. Total leverage is the total risk a business is facing which is the summation of operating leverage and financial leverage,

Before we stress on the point that Total Leverage is the ultimate measurement that an entrepreneur would follow, lets strive upon the two leverage we named above.

Operating Leverage is the use of fixed cost/expenses that a business uses in its running. A higher operating leverage signifies more use of fixed cost which makes the business prone to stress in case sales are not sufficient enough to meet the fixed cost.

On the other hand financial leverage is the amount of debt in the capital structure of the company. Capital structure comprise of Equity(owners fund) and Debt. Use of debt helps in improvement of return on equity for the Equity Shareholders but can lead to acute stress if the sales aren’t sufficient enough as interest on debt financing is fixed and failure to make timely payment can lead to bankruptcy for the business.

Thus total leverage is the ultimate measurement that an entrepreneur has to follow. Excess total leverage in the absence of supporting Revenues can lead to business failing to make payment for fixed expenses and missing interest payments leading to bankruptcy and business discontinuity. On the contrary use of debt financing, if supported with good uptick in revenues can result in magnifying returns for Equity Shareholders (as Debt Financing is usually cheaper than Equity).