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Leverage
Source: Encyclopedia of Banking & Finance (9h Edition) by Charles J Woelfel
(We recommend this as work of authority.)

The 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.

In 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:

1.                   Capitalization:  $200 million 4% bonds, 100,000 shares of $5 preferred, and 10,000 shares of common stock.

2.                   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.

3.                   Should earnings increase 50%, the increase in common stock's earnings would be 143%, as follows:

With 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.

4.                   But should earnings decline 25%, the decline in common stock earnings would be 71%, as follows:

With 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.

5.                   Should earnings decline 35%, there would be no common stock earnings, as follows:

With earnings available of $1.3 million less bond interest of $800,000 and $500,000 preferred dividends, the common stock's earnings are zero.

Leverage is used to explain a firm's ability to use fixed-cost assets or funds to magnify the returns to its owners.

Leverage 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).

Financial 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 formula:                                               

DFL =               Percentage change in earnings per share        
Percentage change in earnings before Interest and taxes

The 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.

Operating 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;                                         

DOL =  Percentage change in earnings before interest and taxes
              Percentage change in sales

The 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.

The degree of total or combined leverage (DTL) is computed as follows:

 DTL =  Percentage change in earnings per share
        Percentage change in sales

Whenever 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.

BIBLIOGRAPHY

PETRUCELLO, R.M. "Investors Can Increase Leverage by Knowing How Lenders Think."  Real Estate Review, Spring, 1988.  


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