leverage

Examples of leverage in the following topics:

• Combining Operating Leverage and Financial Leverage

  • To calculate total leverage, we multiply Degree of Operating Leverage by Degree of Financial Leverage.
  • Operating and financial leverage can be combined into an overall measure called "total leverage. " Total leverage can be used to measure the total risk of a company and can be defined as the percentage change in stockholder earnings for a given change in sales.
  • Total leverage can be determined by a couple of different methods.
  • Another way to determine total leverage is by multiplying the Degree of Operating Leverage and the Degree of Financial Leverage.
  • TL = Total Leverage.

• Impacts of Financial Leverage

  • At an ideal level of financial leverage, a company's return on equity increases because the use of leverage increases stock volatility, increasing its level of risk which in turn increases returns.
  • However, if a company is financially over-leveraged a decrease in return on equity could occur.
  • The most obvious risk of leverage is that it multiplies losses.
  • On the other hand, when debt is taken on for personal use there is no value being created, i.e., no leveraging.
  • There is also a misconception that companies enter a higher level of financial leverage out of desperation, referred to as involuntary leverage.

• Financial Leverage

  • Common ways to attain leverage are borrowing money or buying derivatives.
  • A business entity can leverage its revenue by buying fixed assets.
  • In terms of investments, there exists accounting leverage, notional leverage, and economic leverage.
  • The most obvious risk of leverage is that it multiplies losses.
  • There also exists the risk of involuntary leverage.

• Defining Operating Leverage

  • Operating leverage is a measure of how revenue growth translates into growth in operating income.
  • Therefore, companies with low output would not benefit from increased operating leverage.
  • Therefore, operating leverage is used much more than financial leverage for these types of firms.
  • Operating leverage also increases forecasting risk.
  • Various measures can be used to interpret operating leverage.

• Benefits and Risks of Operating Leverage

  • Leverage, in general, can defined as any technique that is used to multiply gains and losses.
  • By this definition the use of leverage creates risk, and thus will always necessitate a tradeoff between risk and return.
  • In other words, a company with higher operating leverage has the potential to generate much larger profits than a company with lower operating leverage.
  • Just as the use of operating leverage can lead to greater profits, if a company is able to reach a given, break-even point, so too can the use of leverage drastically multiply losses if that point is not reached.
  • Identify the types of companies that would benefit from higher operating leverage

• Defining Financial Leverage

  • At its simplest, leverage is a tactic geared at multiplying gains and losses.
  • The standard definition of financial leverage is as follows:
  • In short, the ratio between debt and equity is a strong sign of leverage.
  • This results in a financial leverage calculation of 40/60, or 0.6667.
  • Before Lehman Brothers went bankrupt, they were leveraged at over 30 times ($691 billion in financial leverage compared to $22 billion in assets).

• Leverage Models

  • Models that allow us to interpret appropriate financial leverage include the Modigliani-Miller theorem and the Degree of Financial Leverage.
  • Further, value may be added by utilizing leverage.
  • Financial leverage can be measured, or defined, using certain ratios.
  • The higher the Degree of Financial Leverage, the riskier the business.
  • Financial leverage is defined as the ratio of operating income to net income.

• Influential Observations

  • The former factor is called the observation's leverage.
  • Observation B has small leverage and a relatively small residual.
  • Observation C has small leverage and a relatively high residual.
  • Observation D has the lowest leverage and the second highest residual.
  • Observation E has by far the largest leverage and the largest residual.

• Leverage Models

  • The relationship between fixed and variable costs, when calculated alongside sales volume, enables modeling of operational leverage.
  • Before learning each calculation, it's useful to frame the issue of leverage first.
  • Operating leverage is largely predicated on fixed costs.
  • Most of the calculations and models for leverage are relatively intuitive when looking at examples.
  • At the core of degree of operating leverage is the same concept discussed in the example above.

• Financial Structures

  • Understand how to qualify and leverage financial incentives through the Small Business Administration (SBA).