Financial Management Unit 3: Leverage Analysis: Developing the Concept of Leverage in Finance.
Computation and inferences of Degree of Operating Leverage, Financial Leverage and Combined Leverage.
Leverage is a general term for any technique to multiply gains and losses. Common ways to attain leverage are borrowing money, buying fixed assets and using derivatives In physics, leverage denotes the use of a lever and a small amount of force to lift a heavy object. Likewise in business, leverage refers to the use of a relatively small investment or a small amount of debt to achieve greater profits. That is, leverage is the use of assets and liabilities to boost profits while balancing the risks involved.
By introducing technology production processes, increase the production, reducing waste and improving quality. When the results are optimal and business goals are achieved, total unit costs should decrease, in short, that this concept is known as operating leverage
Implications:
1.A firm with a high break-even point is more risky than one with a low Break even point. In periods of increasing sales, operating income (OI or EBIT) of the leveraged firm tends to increase rapidly. This increase in OI (EBIT) is the pay-off for being more risky. But in periods of decreasing sales, operating income of the firm tends to decrease rapidly, that is the risk. 2.Firms with small amounts of fixed operating costs have low break-even points and are therefore less risky and have low operating leverage. Variable costs in these firms tend to be high and both the CM and UC are low. In periods of increasing sales, Operating income (EBIT) for these firms tends to increase slowly. But in periods of decreasing sales, Operating income will tend to decrease slowly making the firm less risky. 3.In conclusion, if a company has high operating leverage, then the operating income(OI or EBIT) will become very sensitive to changes in sales volume. Just a small percentage (%) chance in sales can yield (produce) a large percentage change in Operating Income. A Company with low operating leverage the reverse is true
A. An asset that you can borrow against B. A line of credit or loan from a bank at a reasonable interest rate C. Ability to claim interest payments as a tax deduction D. A stable asset to leverage for example, real estate. This means that it is not generally subject to rapid declines in price E. Income from the asset, for instance rent, that you are using leverage to buy. This ongoing cash flow decreases your holding costs F. Enough stable personal cash flow to support the loan repayments, if interest rates increase, or the income from the asset falls G. An higher overall return from the property than the holding costs (after tax and any income)
Financial leverage is one of the biggest benefits of trading options. Leverage is created by making your investments work harder for you to maximize profit. In other words, leveraging is creating potential for bigger gains using a smaller amount of capital. Financial leverage is usually created by using other peoples money in an effort to maximize future profits. Mortgages are used to invest in real estate, and companies borrow money to expand operations. The benefit of the leverage comes from increased property value, or higher company revenue which raises the value of stockholders shares. For the investor, however, buying options provides inherent financial leverage. Without needing to use borrowed capital, by investing in options, you can control a larger number of shares for the same initial investment, than if you purchased the shares themselves.
1.Financial leverage can be very useful to a firm if properly used under the right conditions. For firms in industries that have a degree of stability and/or show growth, the use of debt is recommended because of the positive aspects of financial leverage. BUT.. 2. As a firm increases the use of debt in its capital structure, creditors (lenders) will perceive a greater financial risk in lending money to the firm and therefore may charge a higher interest rate which may lower earnings before tax (EBT). These lenders will perhaps place other restrictions on the firm. Stockholders may become concerned with the risk to EPS and sell the stock (which will force the market price down). 3.In conclusion, financial leverage is a very useful tool if used correctly and under the right conditions. At times, the value of the firm is enhanced by financial leverage
