Introduction to concept of Leverage

Introduction to concept of Leverage: In business, the phrase “leverage” refers to debt or borrowing money to pay for the acquisition of supplies, machinery, and other assets for the firm. To fund or acquire the assets of the business, owners may employ either debt or equity. Leverage, often known as debt, raises a company’s risk of bankruptcy but may also improve earnings and returns, particularly return on equity. This is true as the owner’s equity is not reduced by issuing more shares of stock if debt financing is employed instead of equity financing.

Leverage refers to borrowing when a company wants to grow or invest because it aims to increase the value of the loan for the company or investors.

With debt financing, interest payments are tax deductible regardless of whether they come from a loan or line of credit. Additionally, by paying on time, a firm will have a solid payment history and business credit rating.

Debt financing is preferred by investors in businesses, but only to a certain extent. Investors start to worry about excessive debt financing beyond a certain point since it increases the company’s default risk.

Introduction to concept of Leverage

Dimensions of Leverage

Leverage is the term used to describe the utilization of fixed expenses in an effort to boost profitability. Leverage influences the firm’s total risk and returns by affecting the amount and unpredictability of its after-tax profits. The following factors make the study of leverage important.

• Operating Risk Measuring

The danger that the company won’t be able to pay its fixed running expenses is referred to as operating risk. Larger fixed operating expenses are a sign of increased operational leverage and, therefore, the higher operating risk for the company since operating leverage relies on fixed operating costs. High operational leverage is beneficial while sales are increasing but detrimental when sales are declining.

• Financial Risk Measuring

The danger that the company won’t be able to pay its fixed financial expenses is referred to as financial risk. High fixed financial expenses are a sign of increased operational leverage and higher financial risk since financial leverage is dependent on fixed financial costs. When operational profit is growing, high financial leverage is beneficial; when it is declining, it is detrimental.

• Risk management

Operating and financial leverage have a multiplicative rather than an additive relationship. To achieve the desired amount of total leverage and level of overall business risk, operating leverage and financial leverage may be coupled in a variety of ways.

•  Creating a Balanced Capital Structure

Earnings per share should be correlated with the amount of EBIT under different financial plans in order to build an optimal capital structure mix or financial plan. Analyzing the connection between EBIT and earnings per share is one common method of analyzing the impact of leverage.

• Intensify Profitability

By employing fixed-cost assets and fixed-return sources of capital, a business seeks to demonstrate a high result or higher benefit via leverage. In order to boost a firm’s profitability, it ensures the optimum use of capital and fixed assets. It also helps to understand why a business isn’t making more money.