What is Leverage?
The Meaning of Operating, Financial, and Combined Leverage
Leverage, in business terminology, really just means debt. It's the borrowing of funds to finance the purchase of inventory, equipment, and other company assets. Business owners can use either debt or equity to finance or buy company assets. Using debt increases the company's risk of bankruptcy but can also increase the company's profits and returns; specifically its return on equity. If debt financing is used rather than equity financing, the owner's equity is not diluted by issuing more shares of stock. Borrowing funds in order to expand or invest is referred to as leverage because the goal is to amplify the loan into a greater value for the firm or investors.
With debt financing, regardless of whether the interest charges are from a loan or a line of credit, the interest payments are tax deductible. In addition, by making timely payments, a company will establish a positive payment history and business credit rating.
Investors prefer the business to use debt financing, but only to a certain point. Investors get nervous about too much debt financing as it drives up the company's default risk.
There are three types of leverage:
Breakeven analysis states that there are essentially two types of costs in a company's structure: fixed costs and variable costs. Operating leverage refers to the percentage of fixed costs that a company has. Stated another way, operating leverage is the ratio of fixed costs to variable costs; if a business firm has more fixed costs as compared to variable costs, then the firm is said to have high operating leverage.
A capital intensive firm is one that uses fixed costs, for example those within the automotive industry, as they need a huge amount of equipment to manufacture and service their products. When the economy slows down and fewer people are buying new cars, the auto companies still have to pay their fixed costs, such as overhead on factories, depreciation on equipment, and other fixed costs associated with a capital intensive business.
Compare the high operating leverage of a capital intensive firm to the operating leverage for a labor intensive one: labor intensive firms require greater human capital for the production process, and have less fixed costs. The service businesses that make up much of our economy, such as restaurants and hotels, are labor intensive. In difficult economic times, firms that are labor intensive typically have an easier time surviving than capital intensive firms.
If a firm has high operating leverage, a small change in sales volume results in a large change in return on invested capital (ROIC). In other words, firms with high operating leverage are very sensitive to changes in sales, and this is quickly reflected by their bottom line.
Financial leverage refers to the amount of debt in the accounts of the firm. If you can envision a balance sheet, financial leverage refers to the right-hand side of the balance sheet. Operating leverage refers to the left-hand side of the balance sheet, and accounts for the factory, maintenance, and equipment costs, as well as the mix of fixed assets used by the company.
The use of financial leverage in bankrolling a firm's operations has the ability to improve the returns to shareholders without diluting the firm's ownership through equity financing. Too much financial leverage, however, can lead to the risk of default and bankruptcy.
One of the financial ratios used in determining the amount of financial leverage a business has is the debt/equity ratio, which shows the proportion of debt a firm has versus the equity of its shareholders.
The concept of leverage is used in breakeven analysis and in the development of the capital structure of a business firm. Operating leverage influences the top half of a firm's income statement, and financial leverage influences the bottom half, as well as the earnings per share to stockholders.
Combined, or "total", leverage is the cumulative amount of risk facing a firm, including all other business risks, and is the total amount of leverage that shareholders can use to borrow on behalf of the company.
Business risk refers to a business' likelihood of delivering future returns on the equity of its shareholders.
A component of business risk is variability in product demand. Customers must have food to survive, so even in difficult economic times, the Publix grocery store chain will have less product variability than Ford Motor Company. Customers don't have to buy new cars during an economic crash, but they must eat.
Most businesses have variability in product sales, prices, and input costs throughout the year. Companies that are slow to bring new products to the market face different business risks than those brands that offer new products in rapid succession. Both are significant risks to the financial outlook of the organization.