Financial Leverage & Combined Leverage Numerical and solutions

A leverage ratio is any one of several financial measurements that assesses the ability of a company to meet its financial obligations. A leverage ratio may also be used to measure a company's mix of operating expenses to get an idea of how changes in output will affect operating income. Common leverage ratios include the debt-equity ratio, equity multiplier, degree of financial leverage, and consumer leverage ratio. Banks have regulatory oversight on the level of leverage they are can hold. There are three commonly used measures of leverages in financial analysis. These are: (i) Operating leverage, (ii) Financial leverage, and ADVERTISEMENTS: (iii) Combined leverage. (i) Operating Leverage: Operating Leverage is defined as “the firm’s ability to use fixed operating costs to magnify effects of changes in sales on its earnings before interest and taxes”. In other words operating leverage is the tendency of the operating profit to vary disproportionately with sales. It is said to exist when a firm has to pay fixed cost regardless of volume of output or sales. The operating leverage shows the relationship between the changes in sales and the changes in fixed operating income. Thus, the operating leverage has an impact mainly on fixed costs and also on variable costs and contribution. Of course, there will be no operating leverage if there are no fixed operating costs.

Leverage Analysis

Leverage reflects the responsiveness or influence of one financial variable over some other financial variable. The relationship between sales revenue and EBIT is defined as operating leverage and the relationship between EBIT and EPS is defined as financial leverage. The direct relationship between the sales revenue and the EPS can be established by combining the operating leverage and financial leverage and is defined as combined leverage.

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