QUESTION: Discuss the significance of leverages?
Answer:
MEASUREMENT OF OPERATING RISK: Operating risk refers to the risk of the firm not being able to cover its fixed operating costs. Since, operating leverage depends on operating costs, larger fixed operating costs indicates higher degree of operating leverage and thus, higher operating risk of the firm. High operating leverage is good when sales are rising but bad when they are falling.
MEASUREMENT OF FINANCIAL RISK: It refers to the risk of the firm not being able to cover its fixed financial costs. Since financial leverage depends on fixed financial costs indicates higher degree of financial leverage and thus high financial risk. High financial leverage is good when operating profit is rising and when it is falling.
MANAGING RISK: Relationship between operating leverage and financial leverage is multiplicative rather than additive. Operating leverage and Financial leverage can be combined in a number of different ways to obtain a desirable degree of total leverage and level of total firm risk.
DESIGINING APPROPROATE CAPITAL STRUCTURE MIX: To design an appropriate capital structure mix or financial plan, the amount of EBIT under various financial plans, should be related to earnings per share. One widely used mean of examining the effect of leverage to analyse the relationship between EBIT and earnings per share.
INCREASE PROFITABILITY: Leverage is an effort or attempt by which a firm tries to show high result or more benefit by using fixed costs assets and fixed return sources of capital. It ensures maximum utilization of capital and fixed assets in order to increase the profitability of a firm. It helps to know the reasons not having more profits by a company.