LEVERAGE

We often talk about leverage in our day to day life but what exactly is leverage. Lets try to understand it in most simple words. The first step to success is keeping the basics clear and Financiation pay a great weightage to the same.

As far as dictionary meaning is concerned, leverage means positional advantage or power to act effectively. Now what about financial meaning of leverage .All of us from finance industry or finance education background or any businessman or investor and others must have been using the word leverage day in and day out but what is exact definition of leverage, also we talk about Operating leverage, Financial leverage, Accounting  leverage, Investing leverage but what does these mean and its significance in a businessman, an  analyst or in an investor life. Why a student is being taught leverage & why do all of us know the meaning of leverage, lets us try to understand all this. This post covers only the elementary topics in leverage & advanced level to be covered in upcoming posts.

Leverage is most commonly defined as debt or the degree to which business has borrowed funds. To some extent, it is correct but is it only the business who borrow funds, investor too take an extra privilege by investing through margins(in derivatives), also by investing in fixed assets business entity is taking leverage over operational profit. So, leverage in most simple words with respect to business entity can be defined as use of fixed assets in company’s cost structure. For the purpose of understanding the depth of leverage, this post covers leverage only from business point of view.

Why would any firm make use of  leverage(or we can say fixed costs- in the form of more fixed assets-depreciation, rent(operating) or either in the form of interest(financing)- The answer is very simple because it leads to multiplication of profits. But again during downturn it can lead to multiplication of losses also because it would take time for  a firm to reach at break even point . Also, its beneficial to borrow funds from outside only when cost of borrowed funds is more than cost of equity or in other words equity is giving higher returns than cost of borrowed funds.High leverage means high risk, and with high risks their is always a possibility of higher returns.

 Any firm cost structure can be divided into fixed costs(depreciation, rent, interest on debt etc) & variable costs(cost of raw material purchased, freight  charges, carriage charges etc). The firm which has no fixed cost or minimal fixed cost will reach at its break even point(no profit no loss situation) very soon as compared to the firm which has incurred fixed cost because in first case, their is less of obligations by firm. But, does that mean that firm with minimal fixed cost is better- certainly no. Lets try to understand with an example-

	Firm A	Firm B
Sales(Revenue @Rs. 10 per unit for sales of 100000 units each)	1000000	1000000
Variable Costs(production unit same as sale unit for both firm)	200000(Rs. 2 per unit)	600000(Rs. 6 per unit)
Fixed Operating Cost	500000	150000
Fixed financing Cost(Interest paid)	100000	50000
Net Income(ignoring taxes)	200000	200000

Through the above mentioned table, we can see that firm A is incurring more on fixed expense & Firm B is incurring more on variable expense, but net income for both firms are same. With increase in business operations, fixed cost will remain same but variable cost will increase. Say the number of units produced increases to 2,00,000,in such a scenario firm A will incur profit of Rs. 10,00,000/- & firm B will incur profit of only Rs.6,00,000/-. Also, lets see a reverse that both firm production reduces to 50,000 units. In such a scenario, firm A will incur loss of Rs. 2 lacs & firm B will be at its break even, that is no profit no loss. It means that firm A earnings are more volatile as compared to Firm B but at the same time firm B has more capability of earning if there is an expansion phase because higher risks always leads to the possibility of higher returns. So, the optimal use of leverage can increase the earnings of the firm manifold. Also, over leveraging can multiply losses. With respect to interest expenses, firm can also enjoy tax benefits & thus provide the extra return to its shareholders. But, borrowing from market is beneficial only when its cost if less than the return on equity.

As illustrated above, leverage leads to volatility in business. It is very important for an analyst to understand company leverage because-

•  Leverage increases volatility in earnings of the company, its cash flow, and thereby impact its return & risk characteristics.
• It also helps in understanding the quality of management decisions, & to know about the future   prospects of business.
• It helps in valuation of any company, since future cash flows & discount rates for finding their present value are very much dependent on the degree of leverage of any firm

Thus leverage in its elementary form can be defined as the use of fixed assets in the company’s cost structure & degree of leverage measures how effectively the firm’s fixed cost has been utilized to increase firm’s earnings.

 Read more on Leverage in further posts.