What is Leverage?

Leverage refers to the use of fixed costs—either operational or financial—to magnify the potential return on investment. It reflects how a change in sales or operating profit affects earnings or profitability. The higher the leverage, the greater the risk and reward.

Types of Leverages

• Operating Leverage – Based on fixed operating costs.
• Financial Leverage – Based on fixed financial costs (like interest).
• Combined Leverage – A mix of both operating and financial leverage.

1. Operating Leverage

Operating leverage shows the effect of fixed operating costs on the operating income (EBIT) of a business. It measures the sensitivity of EBIT to changes in sales.

Formula: DOL = Contribution / EBIT

Example:

Contribution = 5,00,000 – 2,50,000 = ₹2,50,000

DOL = 2,50,000 / 1,00,000 = 2.5

2. Financial Leverage

Financial leverage measures the effect of interest costs on the earnings of a company. It shows the sensitivity of earnings per share (EPS) to changes in EBIT.

Formula: DFL = EBIT / (EBIT – Interest)

Example:

DFL = 1,00,000 / 75,000 = 1.33

3. Combined Leverage

Combined or Total Leverage shows the impact of both operating and financial leverage on the company’s earnings. It links changes in sales directly to changes in EPS.

Formula: DCL = DOL × DFL = Contribution / EBT

Using Above Example: DCL = 2.5 × 1.33 = 3.33

Importance of Leverages

• Helps assess business and financial risks.
• Supports capital structure and cost planning.
• Improves profit forecasting and planning.
• Assists in evaluating the impact of fixed cost decisions.

Conclusion

Leverage is a critical concept in financial management. It amplifies profits in good times but increases risk during downturns. A balanced use of operating and financial leverage can enhance returns while managing financial stability.