Concept of Leverage or Gearing - Operating, Financial and Combined Leverage (25% beneficiary set to @null

Introduction

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Sound financial decision must consider the broad coverage of the financial mix which are Capital Structure, Capitalization and Cost of Capital.

Capital structure decisions as a process is a significant function of management since it influences the debt equity mix of the business firm.

It's influence in turn affects the current shareholders risk and return on investment in the company within that period.

Concept of Leverage or Gearing

Leverage/Gearing describes the mix of long term corporate funding provided internally by the shareholders to that contributed externally that is the lenders.

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The debt and equity mix of the company can be independently determined with the help of leverage or gearing.

Determinants of Leverage

• Borrowing Power of the Firm.
• The existence of charges on the Assets.
• The attitude of Shareholders towards Control.
• Relative Cost of Raising Debt and Equity.
• The Level of Anticipated Profit in Relation to Fixed Interest Charges in Debt Capital.

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Borrowing Power of the Firm

This is usually stated in the company's registered article of association. It states the maximum extent at which a company is allowed to borrow from other sources.

The existence of charges on the Assets

These are charges that have been placed on the firm by individuals that is the owners of the assets. There's a fixed charge on users of any of the firm's assets.

The attitude of Shareholders towards Control

Shareholders may not want to dilute their shares which can cause the firm to resolve to borrowing funds from other reliable sources or selling of some of their already owned assets.

Relative Cost of Raising Debt and Equity

Interest charges on borrowed funds from reliable sources may discourage debt. This inturn forces management to result to internal sources of funds.

The Level of Anticipated Profit in Relation to Fixed Interest Charges in Debt Capital

One of the determinants of borrowings is expectations. If expectations is lower than the changes on borrowed funds, the firm can't break even.

Advantages of Leverage or Gearing

• Leverage Effect
• Task Relief
• Lower Required Returns
• There would be no Dilution for Control
• Asset Matching

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Leverage Effect

When the borrowed funds leads to a situation where return on investment couldn't offset the cost of capital and leave surplus return, there's no need to borrow.

The surplus return on investment after paying off the cost of capital is referred to as leverage effect.

Task Relief

Interest on capital is tax deductible always remember that. This means that when the firm borrows money from reliable sources, the interest on borrowed funds will be deducted first before tax.

Lower Required Returns

When a firm borrows funds, it's shareholders are fully aware of the returns or interest accrued on the borrowed funds.

This in turn reduces their expectations of higher returns and then reduces it to lower return on investment because debt has to be paid.

There would be no Dilution for Control

The stand of the shareholders in the firm remains unchanged despite various market conditions the from might experience.

Asset Matching

Making use of debt finance it purchase an asset may allow the period of the loan to match with the expected life of the borrowed or used asset.

Disadvantages of Leverage or Gearing

• Financial Risk
• Shareholders Returns
• Loan Convenant

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Financial Risk

This is because debt and borrowed assets results to obligation of paying regular interest charges and capital.

Failure to meet up for this arrangement, as required by the organisation, results to great financial risks or bad debt accrued.

Shareholders Returns

Shareholders are most likely going to face increased financial risk from a higher level of leverage and may react to this by demanding higher returns from this investment.

Loan Covenant

Loan covenants are usually enshrined in the loan agreement to profit the lenders. This place restriction on the company's action (present or future).

Classification of Leverage

Leverage or Gearing can be classified into three namely:

• Operating Leverage
• Financial Leverage
• Combined Leverage

1. Operating Leverage

It's the company's ability to use fixed operating cost to increase the effect of changes in sales on its earnings before interest and tax. They consist of fixed and variable costs.

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Therefore the variability in earnings before interest and tax when sales of the firm changes is due to its fixed cost.

The higher the cost, the higher the variability in earnings before interest and tax and the lower the cost, the lower the variability in earnings before interest and tax.

Operating leverage measures the effect or change in sales revenue on the level of earnings before interest and tax.

Degree of Operating Leverage

This is the change in the company's earnings before interest and tax due to its change in sales. Operating leverage affects a firm's operating profit.

A company is said to have a higher degree of operating leverage when it employs a great amount of fixed cost and smaller amount of variable cost.

Degree of Operating Leverage therefore depends on the amount of the various cost structure employed by the company.

2. Financial Leverage

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It's the use of fixed charge sources of funds such as debt and preference capital along with the owners equity in the capital structure.

When the company earns more on the assets it purchased with its funds than the fixed cost used, it's a favourable or surplus financial leverage. This will increase the returns on the owners equity.

Unfavorable or deficit financial leverage occurs when the company earns less than the fixed cost used. This will reduce owners equity.

Degree of Financial Leverage

This is the percentage change in taxable profits as a result of in percentage change in earnings before interest and tax.

3. Combined Leverage

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This leverage expresses the relationship between the revenue in the account of sales and taxable income. Both the financial and operating leverage increases the value of the firm.

Operating leverage affects the firm's operating profit while financial leverage affects the firm's earnings before interest and tax.

The combined leverage focuses on the earnings and composite leverage of the firm. The management should properly access wether to use combined leverage or not.

When a company uses both operating and financial leverage, a small change in the level of sales will have a dramatic effect on earnings per share.

Degree of Combined Leverage

The degree of combined leverage is expressed as the percentage in a firm's earnings per share resulting from 1% change in sales.

Conclusion

In my next post, I'd be outlining the mathematical expressions of all the leverages mentioned above with examples that will be calculated using the formulas.