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In business economics, 'to leverage' refers to using borrowed capital for purposes of expanding a company's asset base to increase returns on risk capital. It can be correctly defined as the use of borrowed financial instruments to boost the total returns on investments to the shareholders. Therefore, the word leverage means the amount of debt that a company has used to finance its assets. A highly leveraged company is one that has more debt than equity in its financial accounts. Leverage is commonly confused with margins. The margin is the borrowed money that a firm uses to invest in other financial instruments like the purchase of securities, investment products or insurances with anticipation of getting high returns while leverage is taking on debt to finance a company's asset base to increase production capacity.
Investors study debt and equity to make decisions on the companies to invest in that would put leverage to work on behalf of their businesses. Statisticians help them analyze the return on equity and return on capital employed so that they can adequately determine the investment decisions to make to get the most gains. Using leverage increases a company's chances of bankruptcy, but it provides the company with the opportunity to increase its profits and returns because when debt financing is used rather than equity financing, then the owner and shareholder's equity is not diluted by issuing more shares of stock. This maintains the company's share value.
Investors and businesses prefer leverage and debt financing because the interest payments from the loan are tax deductible. This means that by making timely payments, the business credit rating of the company increases positively. There are 3 types of leverage; operating leverage, financial leverage, and combined leverage.
Operating leverage
Operating leverage is the ratio of fixed costs to the variable costs in a business company. There are two types of costs in the cost structure of companies; fixed costs and variable costs. A company is said to have high operating leverage if it has high fixed costs compared to the variable costs. Companies with high operating leverage are extremely capital intensive. An excellent example of an industry with high operating leverage is the vehicle manufacturing industry. Vehicle manufacturers have high fixed costs of operation like machinery and equipment that house and assemble the vehicle parts. During a financial crumble when the sales are low, the companies still require to spend the same amount of resources for servicing and using the machinery. Their operational costs do not vary with a difference in the market demand. Therefore, an economic slowdown would hurt companies with higher fixed costs and financial leverage than opposing industries like the hospitality industry which has a significantly low operating leverage. The hospitality industry depends mostly on labor inputs, and during the low season, they can easily fire people to maintain a balance in the costs of operations. Their variable costs are more than their fixed costs. Operating leverage, therefore, means that if a company has high operating leverage, then a small change in the sales volumes results in a significant change in the return on the invested capital (ROIC). This is referred to as the business risk of industries.
Financial leverage
This is the amount of debt in the capital structure of a business company. While the operating leverage is concerned with the fixed assets and variable assets that have been invested in equipment and manpower, financial leverage is concerned with the way the company is going to pay for the inputs and operations of the company. The debt to equity ratio is what is used to determine the amount of financial leverage in a company.
Combined leverage
This is the total amount of risk that a business company has. It is the total amount of leverage that is available to a company to magnify the returns from the business. It combines the returns from equipment and fixed assets in operating leverage and the returns from debt financing in financial leverage. This is used to determine the breakeven value of a company by analyzing the income, debt and operational costs of the business in the analysis of the capital structure of the company. Both operating and financial leverages are concerned with determining the company's ability the fixed costs and the fixed cost of interest obligation. The combined leverage is described as either favorable or unfavorable leverage. It is unfavorable if the sales and income increases but unfavorable when the sales and income increases. It is important to maintain a balance between the operational leverage and the financial leverage of a company to minimize the risk and to maximize the returns to the shareholders.
For more detailed information on leverage and the formulas for calculating the amount of leverage please visit finance assignment help online.