Leverage

Leverage is a technique used by firms to quantify risk-return relationship of different capital structures. i.e. a finance manager estimates requirement of funds and before procuring these funds he decides the best mix of funds and its impact on return and risk of shareholder.

In other words leverage represents relationship between two financial variables.  These variables may be cost, output, sales, E.B.I.T, E.P.S etc.

Leverage is of 3 types -

operating, financial & combined.

whenever there is a change in sales, earnings before interest and tax (EBIT) also changes.  Effect of change in sales on EBIT is measured by operating leverage. Operating leverage depends on fixed costs.

Financial leverage measures effect of changes in operating profit or EBIT on Earning per share.  Financial leverage occurs when firm's capital structure contains obligation of fixed financial charges e.g. interest on debenture, preference dividend