term commonly used in finance and accounting to describe the ability of fixed costs to magnify returns to a firm’s owners. operating leverage, a measure of operating risk, refers to the fixed operating costs found in the firm’s income statement. financial leverage, a measure of financial risk, refers to financing a portion of the firm’s assets, bearing fixed financing charges in hopes of increasing the return to its owners. Total leverage is a measure of total risk. The way to measure total leverage is to determine how Earnings Per Share (EPS) is affected by a change in sales.
money borrowed to increase the return on invested capital.
- Banking. The use of funds purchased in the money market or borrowed from depositors to finance interest-bearing assets, principally loans. What banks do, in effect, is invest their depositors’ money in loans at rates high enough to cover the lender’s cost of funds and operating expenses, and yield a profit margin or spread. Leverage increases when bank assets grow at a faster rate than equity capital, such as common stock, which acts as a cushion against losses. To keep leverage from getting too high, which might happen if banks grow too rapidly or make too many risky loans, commercial banks and savings institutions have to keep minimum levels of equity capital in relation to total assets. See also capital; capital ratio; liquidity.
- Finance. The use of debt or senior securities to get a higher return on owner’s equity capital. A firm issuing long-term bonds may be able to earn a higher rate of return from the the bond proceeds, which are often invested in capital equipment, than what it pays the bondholders in interest. The result is financial leverage or capital leverage, because any increase in earnings benefits the corporate owners, not the bondholders. Issuing bonds has several advantages, provided the issuer can meet the debt service payments. Bond interest payments are tax deductible, although stock dividends are not, and a bond issue does not dilute the value of shareholders’ equity. A bond issuer that is too highly leveraged, though, risks default.
In general: use of borrowed funds to increase purchasing power and, ideally, to increase profitability of an investment business.
Operations: extent to which a company’s costs of operating are fixed (rent, insurance, executive salaries) as opposed to variable (materials, direct labor).
Finance: debt in relation to equity in a firm’s capital structure. The more long-term debt there is, the greater the financial leverage. Shareholders benefit from financial leverage to the extent that return on the borrowed money exceeds the interest costs so that the market value of their shares rises.
Personnel: use of additional employees or contractors to complete a task sooner than one person could.
Operating leverage: extent to which a company’s costs of operating are fixed (rent, insurance, executive salaries) as opposed to variable materials, direct labor). In a totally automated company, whose costs are virtually all fixed, every dollar of increase in sales is a dollar of increase in operating income once the breakeven point has been reached, because costs remain the same at every level of production. In contrast, a company whose costs are largely variable would show relatively little increase in operating income when production and sales increased because costs and production would rise together. The leverage comes in because a small change in sales has a magnified percentage effect on operating income and losses. The degree of operating leverage-the ratio of the percentage change in operating income to the percentage change in sales or units sold-measures the sensitivity of a firm’s profits to changes in sales volume. A firm using a high degree of operating leverage has a breakeven point at a relat ively high sales level.
Financial leverage: debt in relation to equity in a firm’s capital structure-its long-term debt (usually bonds), preferred stock, and shareholder’s equity-measured by the debt-to-equity ratio. The more long-term debt there is, the greater the financial leverage. Shareholders benefit from financial leverage to the extent that return on the borrowed money exceeds the interest costs and the market value of their shares rises. For this reason, financial leverage is popularly called trading on the equity. Because leverage also means required interest and principal payments and thus ultimately the risk of default, how much leverage is desirable is largely a question of stability of earnings. As a rule of thumb, an industrial company with a debt to equity ratio of more than 30% is highly leveraged, exceptions being firms with dependable earnings and cash flow, such as electric utilities.
Since long-term debt interest is a fixed cost, financial leverage tends to take over where operating leverage leaves off, further magnifying the effects on earnings per share of changes in sales levels. In general, high operating leverage should accompany low financial leverage, and vice versa.
Investments: means of enhancing return or value without increasing investment. Buying securities on margin is an example of leverage with borrowed money, and extra leverage may be possible if the leveraged security is convertible into common stock. rights, warrants, and option contracts provide leverage, not involving borrowings but offering the prospect of high return for little or no investment.
use of borrowed funds to increase purchasing power and, ideally, to increase the profitability of an investment.
Example: Collins wishes to invest in real estate. The property costs $100,000 and produces Net Operating Income of $10,000 per year. If purchased with all cash, Collins’ annual rate of return is 10% ($10,000 ÷ $100,000). If she leverages the investment by borrowing $75,000, her return on equity may be higher. If the debt cost is 8% ($6,000) annually, the leverage results in a return of 16% ($4,000 ÷$25,000). However, if the debt cost is 12% ($9,000), the leverage is negative because it reduces the return on equity to 4% ($1,000 ÷ $25,000).