effect of trading on the equity, i.e., use of senior capital in capitalization's,
in the form of borrowed funds, bonds, or preferred stock, ranking ahead
of the junior equity, the common stock.
In addition to such capitalization leverage, there is operating
leverage, provided by relatively fixed operating expenses relative to
expanding or contracting sales or revenues.
There is also leverage provided by invested assets (or investment
companies and insurance companies) and earnings assets or deposits (for
banks), relative to stockholders' equity or book value.
periods of rising earnings, leverage works very advantageously for the
junior equity; but conversely, it works very adversely in periods of declining
earnings. Thus, highly leveraged
situations are quite speculative.
Capitalization leverage, for example, works as follows:
million 4% bonds, 100,000 shares of $5 preferred, and 10,000 shares of
With earnings available of $2 million, less bond interest
of $800,000 and $500,000 preferred dividends, the common stock's equity
in earnings is $700,000.
Should earnings increase 50%, the increase in common stock's
earnings would be 143%, as follows:
earnings available of $3 million, less bond interest of $80,000 and $500,000
preferred dividends, the common stock's equity in earnings is $1.7 million.
But should earnings decline 25%, the decline in common stock
earnings would be 71%, as follows:
earnings available of $1.5 million, less bond interest of
$800,000 and $500,000 preferred dividends, the common stock's equity
in earnings is $200,000.
Should earnings decline 35%, there would be no common stock
earnings, as follows:
earnings available of $1.3 million less bond interest of $800,000 and
$500,000 preferred dividends, the common stock's earnings are zero.
is used to explain a firm's ability to use fixed-cost assets or funds
to magnify the returns to its owners.
exists whenever a company has fixed costs.
There are three types of leverage in financial management:
operating, financial, and total leverage.
Financial leverage is a financial technique that uses borrowed
funds or preferred stock (items involving fixed financial costs) to improve
the return on an equity investment.
As long as a higher rate of return can be earned on assets than
is paid for the capital used to acquire the assets, the rate of return
to owners can be increased. This
is referred to as positive financial leverage.
Financial leverage is used in many business transactions, especially
where real estate and financing by bonds or preferred stock instead of
common stock are involved. Financial
leverage is concerned with the relationship between the firm's earnings
before interest and taxes (EBIT) and the earnings available to common
stockholders or other owners. Financial
leverage is often referred to as "trading on the equity."
Operating leverage is based on the relationship between a firm's
sales revenue and its earnings before interest and taxes.
Operating leverage arises when an enterprise has a relatively large
amount of fixed costs in its total costs.
Total leverage reflects the impact of operating and financial leverage
on the total risk of the firm (the degree of uncertainty associated with
the firm's ability to cover its fixed-payment obligations).
leverage arises as a result of fixed financial charges related to the
presence of bonds or preferred stock.
Such charges do not vary with the firm's earnings before interest
and taxes. The effect of financial
leverage is that an increase in the firm's earnings before interest and
taxes results in a greater than proportional increase in the firm's earnings
per share. A decrease in the
firm's earnings before interest and taxes results in a more than proportional
decrease in the firm's earnings per share.
The degree of financial leverage (DFL) is measured by the following
degree of financial leverage indicates how large a change in earnings
per share will result from a given percentage change in earnings before
interest and taxes. Whenever
the degree of financial leverage is greater than one, financial leverage
exists. The higher this quotient
the larger the degree of financial leverage.
Since debt financing incurs fixed interest charges, the ratio of
debt to equity is considered a measure of financial leverage.
leverage refers to the extent that fixed costs are utilized tin the production
process during an operating cycle.
Operating leverage can also be used to measure the impact on earnings
per share of having different levels of fixed to variable costs in manufacEagle
Tradersg products. Earnings
before interest and taxes are related to changes in the variable costs
to fixed cost. As fixed operating
costs are added by the firm, the potential operating profits and losses
are magnified, and are ultimately reflected in the variation in earnings
per share of stock. The Degree
of operating leverage (DOL) is computed as follows;
degree of operating leverage indicates how large a change in operating
profit will result from a given percentage change in sales.
As long as the degree of operating leverage is greater than one,
there is positive operating leverage.
degree of total or combined leverage (DTL) is computed as follows:
the percentage change in earnings per share resulting from a given percentage
change in sales exceeds the percentage change in sales, total leverage
is positive. The total or
combined leverage for a company equals the product of the operating and
financial leverages. Total
leverage indicates a firm's ability to use both operating and financial
fixed costs to magnify the effect of changes in sales on a firm's earnings
per share. The appended exhibit
illustrates the application of leverage to a firm's income statement.
Observe that fixed expenses and interest expense remain unchanged.
Note the section of the statement involved in the computation of
operating, financial and total leverage.
Leverage arises from the fixed expenses and interest expenses that
remain unchanged. Leverage
analysis is an extension of break-even analysis and uses the same basic
information: price, quantity,
variable expenses, and fixed expenses.
R.M. "Investors Can Increase Leverage by Knowing How Lenders Think."
Real Estate Review, Spring, 1988.