In simple word leverage is power and relationship between two interrelated variables. These variables may be output, sale, cost and profit. Finance manager calculates these leverage by apply formula and then uses them for taking decision in favour of company's shareholder. Main aim of leverage testing is maximize the earning of shareholder and reduce the risk of company.
Type of leverage: -
1. Operating Leverage
Operating leverage may be defined as the firm's ability to use fixed operating costs to magnify the effect of changes in sales on its earnings before interest and tax. The relationship between contribution margin and earnings before interest and tax (EBIT) is called degree of operating leverage. It may be defined as the rate of
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At this time, finance manager can get more loan for increasing the earning of shareholders.
2. Financial Leverage
Financial leverage is related with the financing activities of a firm. The fixed return sources of capital influence the earning of variable return sources. The effect is known as financial leverage.
The use of fixed charge capital is known as financial leverage. If there is no fixed charge capital, there is no financial leverage. The proper utilization of fixed charged capital like debentures, bonds, bank loan and preference share capital is measured by financial leverage. The firm having more debt capital and preference share capital in its capital structure has higher degree of financial leverage and greater amount of risk.
Financial leverage is used to measure the financial risk. Financial risk refers to the risk of the firm not being able to cover its fixed financial costs.
Formula for calculating financial leverage
= % change in Earning per share / % change in earnings before interest and
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→ Good combination is that in which lower operating leverage with high financial leverage
AIRLINE OPERATING LEVERAGE
The degree of leverage varies considerably among carriers. A positive degree of leverage indicates that carriers’ profit will increase at a greater rate than an increase in sales. For example, a degree of leverage of 1.2 means that for every 1% increase/decrease in sales the airlines Operating Profits will increase/decrease by 1.2%. A carrier with a degree of leverage between 0 to 1 will be anomaly to this degree of leverage equation because it can only exist when the firm is experiencing an operating loss and suggests that it will be better off by selling less tickets. A negative degree of leverage indicates a carrier would be experiencing an Operating Profit, but would also have incurred annual Fixed Costs that are greater than Operating Profit and thus incurring an annual net loss. This problem should be addressed by reducing Fixed costs or by increasing
Financial Leverage Analysis Regarding financial leverage, the debt percentage ratio increased from 84.95% to 89.92%, indicating an increase in the amount of The Home Depot’s assets that are financed with debt. The debt to equity ratio drastically increased, from 5.65 to 8.92, showing a drastically increased amount of financial leverage in the company. This may not always be good for a company, as it means there is a very large amount of debt. However, the quick ratio had virtually no change (decreased by .01), showing that an increase in debt and financial leverage did not affect cash and cash equivalents. In fact, cash and cash equivalents increased, as stated in the above paragraph citing vertical analysis.
Higher leverage is very likely to create value for a firm considering capital structure change by exerting financial discipline and more efficient corporate strategy changes.
The 3 percent decline in sales causing a 21 percent decline in profits can be attributed to the identification of the accounting concept of operating leverage. Operating leverage is what business managers apply to boost small changes in revenue into sizable changes in profitability. Fixed cost is the force managers use to attain disproportionate changes between revenue and profitability. Therefore, when all costs are fixed every sales dollar contributes one dollar toward the potential profitability of a project. Once sales dollars cover fixed costs, each additional sales dollar represents pure profit. A small change in sales volume can significantly affect profitability (Edmonds, Tsay, & Olds, 2011). So, therefore, if sales volume increases,
Ratio analysis are useful tools when judging the performance of a company by weighing and evaluating the operating performance (Block-Hirt). There are 13 significant ratios that can separate by four main categories, profitability, asset utilization, liquidity and debt utilization ratios. The ratio analysis covered here consists of eight various ratios with at least one from each of these main categories. These ratios were used to compare and contrast the performance of Verizon versus AT& T over the years 2005 and 2006.
The benefits of these assumptions are that while maintaining the current growth rate of 13%; we can maintain our COGS. One of the major factors contributing to the firm’s poor profit margin is operating expenses.
Financial risks include general ledger accounting, accounts receivable risk, accounts payable accounting risk, the risk of payroll, fixed assets accounting risk, cash management risk and cost accounting risks.
What do you understand by the phrase “stakeholder analysis”? Attempt a stakeholder analysis of an organisation that you are closely associated with.
The financial manager is responsible for giving financial advice and support to clients and colleagues that will enable them to make good business decisions. Particular work environments differ considerable and involve both public and private sector organizations such as retailers, corporations, financial institutions, charities, and even small manufacturing companies and schools (Financial Manager, 2011).
residual earnings growth from 2009 to 2010, and then dividing this figure by the difference between the cost of equity and the residual growth.
Fluctuations in the market-to-book ratio have considerable and lasting effects on leverage. Paper shows that these results are most consistent with market timing theory. None of tradeoff, pecking and managerial entrenchment theories can explain impact on capital structure. All of earlier mentioned theories have some significant flaws. Market timing theory looks as best explanation of empirical results in the sense that capital structure is a cumulative outcome of attempts to time the market.
Thesis: Businesses deem financing necessary when they are just beginning, expanding, or recovering; Debt financing and equity financing have many advantages and disadvantages but also change the entire accounting method that is to be considered while running the business. Debt financing has both advantages and disadvantages. Debt financing is a business’ way to start up, expand, or recover by borrowing money from a person or company. The money borrowed has to be paid back along with the interest that was accrued during the length of time the loan was carried out. This option is great for company’s that do not want investors.
No firm can be a success without some form of risk management. Risk are the uncertainty in investments requiring an assessment. Risk assessment is a structured and systematic procedure, which is dependent upon the correct identification of hazards and an appropriate assessment of risks arising from them, with a view to making inter-risk comparisons for purposes of their control and avoidance (Nikolić and Ružić-Dimitrijevi, 2009). ERM is a practice that firms implement to manage risks and provide opportunities. ERM is a framework of identifying, evaluating, responding, and monitoring risks that hinder a firm’s objectives. The following paper is a comparison and evaluation to recommended practices for risk manage using article “Risk Leverage
Financial institutions (banks and other lending companies) use them to decide whether to grant a company with fresh working capital or extend debt securities (such as a long-term bank loan or debentures) to finance expansion and other significant expenditures.
The capital structure of a firm is the way in which it decides to finance its operations from various funds, comprising debt, such as bonds and outstanding loans, and equity, including stock and retained earnings. In the long term, firms seek to find the optimal debt-equity ratio. This essay will explore the advantages and disadvantages of different capital structure mixes, and consider whether this has any relevance to firm value in theory and in reality.
Sources of finance are the different methods for a business to earn and obtain money. There are lots of ways to obtain money but two large basic sources of finance, which are the “owner’s capital” and “capital borrowed”. They are also called internal sources of finance and external sources of finance. In those sources, they are mainly divided in two groups, which are short-term sources of finance and long-term sources of finance.