OPERATING FINANCIAL AND COMBINED LEVERAGE
The purpose of this Chapter is to set forth a framework for the financing decision of a firm. It discusses the principles and types of leverage. As mentioned earlier, a firm can make use of different sources of financing whose costs are different. These sources may be for purposes of exposition, classified into those which carry a fixed rate of return and those on which the returns vary. The fixed returns on some sources of finance have implications for those who are entitled to a variable return. Thus, since debt involves the payment of a stated rate of interest the return to the ordinary shareholders is affected by the magnitude of debt in the capital structure of a firm.
The employment of an asset or source of funds for which the firm has to pay a fixed cost or fixed return may be termed as leverage. Consequently, the earnings available to the shareholders as also the risk are affected. If earnings less the variable costs exceed the fixed cost or earnings before interest and taxes exceed the fixed return requirement the leverage is called favorable. When they do not, the result is unfavorable leverage.
There are two types of leverage--operating and financial. The leverage associated with investment (asset acquisition) activities is referred to as operating left while leverage associated with financing activities is called financial leverage. While we are basically concerned with financial leverage for purposes of the financing decision of a firm, the discussion of operating leverage is to serve as background to the understanding of financial leverage because the two types of leverage are closely related.
Operating leverage is determined by the relationship between the firm's sales revenues and its earnings before interest and taxes (EBIT). The earnings before interest and taxes are also generally called as operating profits. Financial leverage represents the relationship between the firm's earnings before interest and taxes (operating profits) and the earnings available for ordinary shareholders. The operating profits (EBIT) are, thus, used as the pivotal point in defining operating and financial leverage. In a way, operating and financial leverage represent two stages in the process of determining the earnings available to the equity shareholders and hence, their discussion in this chapter. Apart from the elaboration of the return-risk implications, their Combined effect has also been discussed. Section 1 of the Chapter discusses the operating leverage while financial leverage is covered in Section 2. The combined leverage is illustrated in Section 3 and points are summarized in Section 4.