LEVERAGE
Leverage is a practice which can help a business drive up its gains or
losses. In business language, if a firm has fixed expenses in P/L account
or debt in capital structure , the firm is said to be levered. Nowadays,
almost no business is away from it but very few have struck a balance.
According to J. C. Van Home: “Leverage is the employment of an asset
or funds for which the firm pays a fixed cost of fixed return.”
In finance, leverage is very closely related to fixed expenses. We can
safely state that by the introduction of expenses which are fixed in
nature, we are leveraging a firm. By fixed expenses, we refer to the
expenses, the amount of which remains unchanged irrespective of the
activity of the business. For example, an amount of investment made in
fixed assets or interest paid on loans does not change with a normal
change in a number of sales. Neither they decrease with a decrease in
sales and nor they increase with an increase in sales.
Types of Leverage
There is a different basis for classifying business expenses. For our
convenience, let us classify fixed expenses into operating fixed expenses
such as depreciation on fixed expenses, salaries etc., and financial fixed
expenses such as interest and dividend on preference shares. Similar to
them, leverages are also of two types – financial and operating.
, Financial Leverage (FL)
It is a leverage created with the help of debt component in the capital
structure of a company. Higher the debt, higher would be the FL because
with higher debt comes the higher amount of interest that needs to be
paid. It can be both bad and good for a business depending on the
situation. If a firm is able to generate a higher return on investment
(ROI) than the interest rate it is paying, leverage will have its positive
effect shareholder’s return. The darker side is that if the said situation is
opposite, higher leverage can take a business to a worst situation like
bankruptcy.
Example 1
Bob and Jim are both looking to purchase the same house that costs
$500,000. Bob plans to make a 10% down payment and take a $450,000
mortgage for the rest of the payment (mortgage cost is 5% annually). Jim
wants to purchase the house for $500,000 cash today. Who will realize a
higher return on investment if they sell the house for $550,000 a year
from today?
BOB JIM
DOWN PAYMENT $50,000 $500,000
DEBT $450,000 0
COST OF DEBT $22,500 0
SALE OF HOUSE $550,00 0
$550,000 $550,000
PROFIT (AFTER DEBT PAID) $27500 $50,000
RETURN ON INVESTMENT (ROI) 55% 10%
Although Jim makes a higher profit, Bob sees a much higher return on
investment because he made $27,500 profit with an investment of only
$50,000 (while Jim made $50,000 profit with a $500,000 investment).
Leverage is a practice which can help a business drive up its gains or
losses. In business language, if a firm has fixed expenses in P/L account
or debt in capital structure , the firm is said to be levered. Nowadays,
almost no business is away from it but very few have struck a balance.
According to J. C. Van Home: “Leverage is the employment of an asset
or funds for which the firm pays a fixed cost of fixed return.”
In finance, leverage is very closely related to fixed expenses. We can
safely state that by the introduction of expenses which are fixed in
nature, we are leveraging a firm. By fixed expenses, we refer to the
expenses, the amount of which remains unchanged irrespective of the
activity of the business. For example, an amount of investment made in
fixed assets or interest paid on loans does not change with a normal
change in a number of sales. Neither they decrease with a decrease in
sales and nor they increase with an increase in sales.
Types of Leverage
There is a different basis for classifying business expenses. For our
convenience, let us classify fixed expenses into operating fixed expenses
such as depreciation on fixed expenses, salaries etc., and financial fixed
expenses such as interest and dividend on preference shares. Similar to
them, leverages are also of two types – financial and operating.
, Financial Leverage (FL)
It is a leverage created with the help of debt component in the capital
structure of a company. Higher the debt, higher would be the FL because
with higher debt comes the higher amount of interest that needs to be
paid. It can be both bad and good for a business depending on the
situation. If a firm is able to generate a higher return on investment
(ROI) than the interest rate it is paying, leverage will have its positive
effect shareholder’s return. The darker side is that if the said situation is
opposite, higher leverage can take a business to a worst situation like
bankruptcy.
Example 1
Bob and Jim are both looking to purchase the same house that costs
$500,000. Bob plans to make a 10% down payment and take a $450,000
mortgage for the rest of the payment (mortgage cost is 5% annually). Jim
wants to purchase the house for $500,000 cash today. Who will realize a
higher return on investment if they sell the house for $550,000 a year
from today?
BOB JIM
DOWN PAYMENT $50,000 $500,000
DEBT $450,000 0
COST OF DEBT $22,500 0
SALE OF HOUSE $550,00 0
$550,000 $550,000
PROFIT (AFTER DEBT PAID) $27500 $50,000
RETURN ON INVESTMENT (ROI) 55% 10%
Although Jim makes a higher profit, Bob sees a much higher return on
investment because he made $27,500 profit with an investment of only
$50,000 (while Jim made $50,000 profit with a $500,000 investment).
