Types of Leverage: Advantages and Disadvantages

Debt is bad, as we've all heard. However, this is not always the case. Debt can be used to build credit, start building equity through the purchase of a new home, or even leverage it to make a profit-generating investment. 

 

Debt can also be referred to as leverage. Leverage is frequently used in business to refer to borrowing funds to finance the purchase of inventory, equipment, or other assets. To finance those purchases, businesses use leverage rather than equity. 

 

Leveraging is when you use borrowed money - such as loans, securities, capital, or other assets - for an investment in order to potentially increase the return on that investment. We have covered leverage in-depth in this article below. 

 

 

What is Leverage?

 

Leverage is an investment strategy that involves borrowing money to increase the potential return on investment. It can be used in business, professional trading, and even to finance a home. Leverage can also refer to the amount of debt a company uses to fund an asset, which is referred to as financial leverage.

 

While leverage may increase an investment's returns, there is a drawback: if the investment does not work out, it may increase the potential risk and loss of the investment.

 

Leverage is the use of borrowed capital (debt) to fund an investment or project. As a result, the potential returns from a project are multiplied. Simultaneously, leverage multiplies the potential downside risk if the investment does not pan out. When a company, property, or investment is referred to as "highly leveraged," it means that it has more debt than equity.

 

Both investors and businesses use the concept of leverage. Leverage is used by investors to significantly increase the returns on their investments. They leverage their investments by utilizing various instruments such as options, futures, and margin accounts. 

 

Companies can use leverage to finance their assets. In other words, rather than issuing stock to raise capital, businesses can use debt financing to invest in business operations in an attempt to increase shareholder value

 

Types of Leverage

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Types of Leverage

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1. Operating Leverage

 

Operating leverage is concerned with the firm's investment activities. It refers to the incorporation of fixed operating costs into the firm's revenue stream.

 

The firm can magnify the effect of changes in sales on changes in EBIT by using fixed costs. As a result, operating leverage refers to a company's ability to use fixed operating costs to magnify the effects of changes in sales on earnings before interest and taxes.

 

This leverage is related to changes in sales and profit. The more fixed operating expenses there are in the cost structure, the greater the degree of operating leverage. The DOL is defined as the percentage change in earnings before interest and taxes relative to a given percentage change in sales and output. 

 

It is an interesting fact that a change in sales volume results in a proportionate change in a firm's operating profit due to the firm's ability to use fixed operating costs. The degree of operating leverage should have a value greater than one.

 

Importance of Operating Leverage

 

• It illustrates the impact of changes in sales on the firm's operating income.
• A high degree of operating leverage magnifies the effect of a small change in sales volume on EBIT.
• A high level of operating leverage implies an increase in operating profit or EBIT.
• High operating leverage is caused by a higher proportion of fixed costs in a firm's total cost structure, resulting in a low margin of safety.
• High operating leverage indicates that more sales are required to reach the break-even point.
• A higher fixed operating cost in a firm's total cost structure promotes higher operating leverage and risk.
• Lower operating leverage provides a sufficient cushion to the firm by providing a high margin of safety against sales variation.

 

2. Combined Leverage

 

Total fixed charges are incurred by a company in the form of fixed operating costs and fixed financial charges. Operating leverage is concerned with operational risk and is quantified by DOL. Financial leverage is associated with financial risk and is quantifiably expressed by DFL. 

 

Fixed charges are a concern for both leverages. When we combine these two, we get the total risk of a firm, which is associated with the firm's total leverage or combined leverage. The risk of not being able to cover total fixed charges is primarily associated with combined leverage.

 

The ability of a company to cover the sum of its fixed operating and financial charges is referred to as combined leverage. The percentage change in EPS to a given percentage change in sales is referred to as the Degree of Combined Leverage (DCL). 

 

DCL is a quantitative expression for combined leverage. The greater the proportion of fixed operating costs and financial charges, the greater the degree of combined leverage. The value of combined leverage, like the other two leverages, must be greater than one.

 

Importance of Combined Leverage

 

• It represents the impact that changes in sales will have on EPS.
• It depicts the combined effect of operating and financial leverage.
• High operating leverage combined with high financial leverage is a very risky situation because the sum of the two leverages is a multiple of these two leverages
• A combination of high operating leverage and low financial leverage indicates that management should exercise caution because the high risk associated with the former is offset by the latter.
• Because keeping the operating leverage at a low rate allows full use of debt financing to maximize return, a combination of low operating leverage and high financial leverage provides a better situation for maximizing return and minimizing risk factors. 

In this case, the firm achieves its break even point while maintaining a low level of sales and a low level of business risk.

• Low operating leverage combined with low financial leverage indicates that the firm is missing out on profitable opportunities.

 

3. Finance Leverage

 

Financial leverage is primarily related to a firm's capital structure's mix of debt and equity. The presence of fixed financial charges in the firm's income stream causes financial leverage.

 

As a result, financial leverage can be defined as a company's ability to use fixed financial charges to magnify the effects of changes in EBIT on EPS. The greater the proportion of fixed charge-bearing funds in a firm's capital structure, the greater the Degree of Financial Leverage (DFL), and vice versa.

 

DEL is a quantitative expression of financial leverage. Degree of Financial Leverage is defined as the percentage change in earnings per share to a given percentage change in earnings before interest and taxes (DFL).

 

Importance of Finance Leverage

 

• It aids the financial manager in developing an optimal capital structure. The optimal capital structure is the combination of debt and equity that results in the lowest overall cost of capital and the highest firm value.
• It raises both earnings per share (EPS) and financial risk.
• A high level of financial leverage indicates the presence of high financial fixed costs as well as high financial risk.
• It aids in balancing financial risk and return in the capital structure.
• It displays the excess of the return on investment over the fixed cost of using the funds.
• It is a useful tool in the hands of the finance manager when determining the amount of debt in the firm's capital structure.

 

4. Working Capital Leverage

 

Working capital investment has a significant impact on a company's profitability and risk. A decrease in current asset investment leads to an increase in firm profitability and vice versa. 

 

Because current assets are less profitable than fixed assets, this is the case. Reduced investment in current assets raises the volume of risk. Risk and return are inextricably linked.

 

As a result, as risk rises, so does the firm's profitability. Thus, Working Capital Leverage (WCL) can be defined as the firm's ability to magnify the effects of changes in current assets on the firm's Return on Investment (assuming current liabilities remain constant) (ROI).

 

Also Read | Introduction to EBITDA 

 

 

Advantages and Disadvantages of Leverage

 

As with any other financial instrument, leverage has advantages and disadvantages that you should be aware of before employing it in your business or personal investments. 

 

Because leverage is a multifaceted financial tool, it is somewhat complex in nature and can increase both gains and losses when used by a business or an individual investor. Understanding its benefits and drawbacks will help you expand your business and determine whether your company is ready to use this financial tool just yet.

 

The following are the benefits and drawbacks of leverage:

 

Advantages

 

1. The most significant advantage of leverage is that it increases the liquidity available to the company because when a company takes out a loan or debt, it receives cash from the lender, and that cash can be used for a variety of activities. 

 

These activities include purchasing new machinery or constructing a new building, which will increase the efficiency of the company, or the company can use the cash to purchase other companies, which will increase the scale of operations of the company, and so on.

 

2. Another advantage of leverage is that in the case of a growing company that requires cash for its operations, the use of debt can result in a multiplication of profits for the company. 

 

This is because the cost of debt is between 8 and 15%, whereas the rate of profits in the case of a growing company can range from 20% to 100%. As a result, as long as the company is growing, leverage tends to magnify the company's profits.

 

3. Another advantage of leverage is that companies that do not want to dilute their ownership can use this route of financing because in the case of debt financing or loan, the company must repay the principal amount on maturity along with periodic interest and there is no risk of giving equity to anyone, resulting in complete control of the company by the company's owners.

 

Disadvantages 

 

1. The most significant disadvantage of leverage is that there is a risk that a company will use too much leverage, which can lead to problems for the company because there will be no benefit to taking leverage beyond an optimum level of leverage. 

 

As a result, companies that earn average or below-average profits can use leverage to do more harm than good. This financial risk is particularly high in certain industries, such as construction, oil production, and automobile construction, which may suffer the greatest losses if asset values fall.

 

2. When leverage investment is not used properly, it can be fatal to businesses and even cause them to fail. This is especially true for businesses that have less predictable income and are less profitable. 

 

This is also why many first-time investors are advised to avoid using leverage until they have gained sufficient experience to avoid such a significant loss to their business.

 

Also Read | Equity Financing

 

What is Leverage in Trading?

 

So, what exactly is leverage? Leverage is the ratio applied to the margin amount to determine how large trade will be placed. Understanding margin and leverage, as well as the distinction between the two, can be difficult at times. 

 

It is critical to understand that margin is the amount of capital required to open a trade. Find out more about margin accounts. Leverage of 10:1 means that the required margin to open and maintain a position is one-tenth of the transaction size.

 

As an example, if a trader wanted to make a Rs 10,000 trade on a financial asset with a 10:1 leverage, the margin requirement would be Rs 1,000. It is critical for all traders to be aware of the risks associated with leveraged trading.

 

Novice traders should exercise extreme caution when practicing margin trading. It is best to be more cautious and use less leverage.

 

Conclusion

 

Borrowing money enables businesses and individuals to make investments that would otherwise be out of reach, or to use their existing funds more efficiently. Individuals may find that using leverage is the only way to afford certain large-ticket items, such as a home or a college education.

 

While leverage has a lot of upside potential, it can also end up costing you a lot more than you borrowed, especially if you can't keep up with interest payments.

 

This is especially true if you invest money that isn't your own. Leverage, at least when it comes to investing, should be reserved for seasoned pros until you have experience—and can afford to lose money.