{"id":6178,"date":"2022-11-09T16:26:22","date_gmt":"2022-11-09T16:26:22","guid":{"rendered":"https:\/\/commerceiets.com\/?p=6178"},"modified":"2022-11-09T16:26:22","modified_gmt":"2022-11-09T16:26:22","slug":"3-types-of-leverage-in-financial-management","status":"publish","type":"post","link":"https:\/\/commerceiets.com\/3-types-of-leverage-in-financial-management\/","title":{"rendered":"3 TYPES OF LEVERAGE IN FINANCIAL MANAGEMENT – OPERATING, FINANCIAL AND COMBINED LEVERAGE"},"content":{"rendered":"\n
TYPES OF LEVERAGE IN FINANCIAL MANAGEMENT – OPERATING, FINANCIAL AND COMBINED LEVERAGE<\/h6>\n\n\n\n

LEVERAGE<\/strong><\/h2>\n\n\n\n

Leverage refers to debt or to the borrowings of funds to finance the purchase of the company\u2019s asset. It is used to measure the effect of increase or decrease of fixed cost on the earnings.<\/p>\n\n\n\n

Leverage may be<\/p>\n\n\n\n

\"TYPES
TYPES OF LEVERAGE IN FINANCIAL MANAGEMENT<\/figcaption><\/figure>\n\n\n\n

ACCORDING TO THE JAMES HORNE: <\/strong>\u201cLeverage can be defined as the employment of an asset or funds for which the firm pays a fixed cost or fixed return.\u201d<\/p>\n\n\n\n

TYPES OF LEVERAGE<\/strong><\/h2>\n\n\n\n

The following are the types of leverages:<\/p>\n\n\n\n

\"TYPES
TYPES OF LEVERAGE IN FINANCIAL MANAGEMENT<\/figcaption><\/figure>\n\n\n\n

FINANCIAL LEVERAGE OR TRADING ON EQUITY<\/strong><\/h2>\n\n\n\n

Financial leverage may be expressed when the residual net income (earnings after interest and taxes and preference dividend) varies not in proportion with operating profit. This leverage reveals the changes in the taxable income in comparison with the changes in the operations.<\/p>\n\n\n\n

In other words, a major part is played by the interest on debt financing, interest on debentures, preference dividend in the entire capital structure of the firm.<\/p>\n\n\n\n

\"TYPES
TYPES OF LEVERAGE IN FINANCIAL MANAGEMENT<\/figcaption><\/figure>\n\n\n\n

The firm may be called as high levered if it has more use of debt and less levered if it has less use of the debt.<\/p>\n\n\n\n

Types of financial leverage: <\/strong>The financial leverage are of two types:<\/p>\n\n\n\n

Favourable financial leverage: <\/strong>When the EPS (earning per share) increases as an impact of debt financing in the corporate structure, it is called favourable leverage.<\/p>\n\n\n\n

Unfavourable financial leverage: <\/strong>When the EPS (earnings per share) decreases as an impact of debt financing in the corporate capital structure, it is called unfavourable financial leverage.<\/p>\n\n\n\n

DEGREE OF FINANCIAL LEVERAGE: <\/strong><\/h3>\n\n\n\n

The degree of financial leverage is the percentage change in taxable profit as a result of percentage change in the operating profit i.e. the ability of the firm to utilize financial charges in order to magnify the effect of changes in EBIT on EPS of the firm.<\/p>\n\n\n\n

\"TYPES
TYPES OF LEVERAGE IN FINANCIAL MANAGEMENT<\/figcaption><\/figure>\n\n\n\n

EPS= Earnings per share<\/p>\n\n\n\n

EBIT= Earnings before interest and tax<\/p>\n\n\n\n

DFL= Degree of financial leverage<\/p>\n\n\n\n

Example: <\/strong>10,000 equity shares @ \u20b910 each= \u20b91,00,000<\/p>\n\n\n\n

10%; 500 debentures of \u20b9100 crores= \u20b950,000<\/p>\n\n\n\n

EBIT= 40,000; Find DFL<\/p>\n\n\n\n

Answer: <\/strong>DFL= EBIT\/ EBIT-I<\/p>\n\n\n\n

= 40,000\/ 40,000-5,000<\/p>\n\n\n\n

= 40,000\/ 35,000<\/p>\n\n\n\n

= 1.14<\/p>\n\n\n\n

Interest= 50,000*10%<\/p>\n\n\n\n

TRADING ON EQUITY: <\/strong><\/h2>\n\n\n\n

Sometimes \u2018financial leverage\u2019 is called \u2018Trading on equity\u2019. This is a device by which the equity shareholders enjoy large amount of profit at the cost of other fixed interest-bearing securities.<\/p>\n\n\n\n

The rate of dividend of the equity shares can substantially be increased by the issue of more debentures and preference shares with the fixed rate of interest and the dividend.<\/p>\n\n\n\n

Example: <\/strong>Suppose, the total requirement of the capital of the company is \u20b920,00,000 and the expected rate of return on the capital is 12%. If the entire capital consists of the equity shares only, there will be no Trading on equity, but will simply be a return @12% on \u20b920,00,000 by way of the dividends.<\/p>\n\n\n\n

Now, suppose the capital structure of the company is:<\/p>\n\n\n\n

10% debentures= \u20b98,00,000<\/p>\n\n\n\n

85 Preference shares= \u20b94,00,000<\/p>\n\n\n\n

Rate of return= 12%<\/p>\n\n\n\n

Profit= 20,00,000*12%= \u20b92,40,000<\/p>\n\n\n\n

Profit<\/td>2,40,000<\/td><\/tr>
Less: Debentures Interest<\/td>(80,000)<\/td><\/tr>
Less: Preference dividend<\/td>(32,000)<\/td><\/tr>
 <\/td>1,28,000<\/td><\/tr><\/tbody><\/table><\/figure>\n\n\n\n

Balance available for equity dividend= \u20b91,28,000<\/p>\n\n\n\n

Percentage of return on equity capital= (1,28,000\/ 8,00,000) *100= 16%<\/p>\n\n\n\n

So by the issue of the debentures and preference shares, trading on equity is possible and as a result the rate of equity dividend increased from 12% to 16%.<\/p>\n\n\n\n

EFFECT OF FINANCIAL LEVERAGE ON EPS<\/strong><\/p>\n\n\n\n