What is leverage in finance?

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Leverage applies to the relationship between credit and equity capital invested in a financial transaction. By reducing the initial capital that is necessary to provide an increase in profitability.

The increase in leverage also increases the risks of the operation, since it causes less flexibility or increased exposure to insolvency or inability to meet payments.

Types of leverage

Operating leverage

It is derived from the existence in the business of fixed operating costs, which do not depend on the operations. Thus, an increase in production leads to an increase in the number of units produced.

An increase in variable costs and other operating expenses also boost growth of a company.

Operating leverage is usually determined from the division between the growth rate of profit and the rate of sales growth.

Operating leverage refers to the tools that the company uses to produce and sell, these tools are the machines, people and technology. The machinery and the people are related to sales.

When there is no leverage, it is said that the company has tied-up capital, that means assets that do not produce money.

Degree of operating leverage

Given the movements or changes in sales volume, it follows that there will be a more than proportional change in the profit or loss from operations. The Degree of Operating Leverage (DOL) is the quantitative measure of the sensitivity of the company’s operating profit to a change in sales or production.

Degree of operating leverage to Q units:

[EC1]: GAO = \ frac {\ Delta \% EBIT} {\ Delta \% SALES} \, \!

Recalling that changes in EBIT and should be prospective SALES.

Other alternative formulas derived [EC1]:

[EC2.0]: GAO = \ frac {Q (P – V)} {Q (P – V) – FC} = \ frac {Q} {(Q – Q_ {EQ})} \, \!

In the case of [EC2.0] has the degree of leverage to Q units.

[EC2.1]: GAO = \ frac {S – VC} {S – VC – FC} = \ frac {EBIT + FC} {EBIT} \, \!

In the case of [EC2.1] have the S leveraged to sales.

Recalling that: Q are units produced and sold. Q_ {EQ} are units that balance is achieved.

FC are fixed costs. VC are variable costs. P is the price per unit. V are the variable costs per unit. S sales / production in monetary units (eg dollars) EBIT is earnings before interest and taxes.

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