What Is Leverage in Finance: Leverage Definition and Concepts
Leverage or “leverage” is a widely applicable issue in and outside the financial world; a term that comes from “leveraging” and that is so broad that it can even be spoken of as logistics leverage.
Let us go into the concept of financial leverage, types, characteristics and formulas, but not before evaluating some previous concepts for a better understanding.
What is the leverage?
The concept of financial leverage is somewhat complex.
We can see leverage as the manoeuvre that a company’s management can carry out in the use of fixed costs and charges within the economic structure (assets) or capital structure (liabilities-equity) so that an increase in income results in a greater breadth of profit.
Leverage is like a springboard through which company management catapults profitability, without neglecting the associated risk.
We also do “financial leverage” when we take on debts.
Loans allow us to acquire fixed assets or capital for work. With them, we promote our businesses in exchange for an interest payment, which in turn is subject to a tax deduction.
This reflects the concept of financial leverage and its types: Operational, financial and combined leverage.
The concept of leverage tells us that we leverage in finance when we use some mechanism, for example, a loan to increase the amount of money we spend on an investment.
Such definition corresponds to “financial leverage”.
Remember that any business or company has fixed assets and with them fixed expenses or costs, that is, those that are not affected by changes in income.
When looking to increase sales, the fixed costs per unit are reduced in increasing profits and there the business management is leveraging, it is “operating leverage”.
Some previous concepts to understand leverage
Leveraging or leveraging in the financial world involves several concepts or prerequisites. The proper application of the term depends on the understanding of each one.
Let’s spend a few short paragraphs reinforcing some of the requirements used in the concept of financial leverage; if you already manage them, you can advance to other sections of the post.
EBIT or UAII
EBIT stands for Earnings Before Interest and Taxes or, which is the same, Earnings Before Interest and Taxes (UAII). It depends on what the authors in finance call it.
The truth is that it corresponds to the operating result or operating income of the business. It is the “operating profit” or profit resulting from subtracting the costs and expenses of the business line from sales income.
Based on the income statement, it is possible to obtain EBIT as follows:
Billing
(-) Discounts and returns
= Sales revenue
(-) Direct costs
= Gross profit or result
(-) Administrative and sales expenses
= UAII.
The income statement
It is the second financial statement of business after the balance sheet. In it we find all the “temporary or nominal” accounts, that is, those income statements that, on an annual basis, undergo an accounting closing process.
The income statement (formerly “misnamed” profit and loss statement) collects all the results of the business and serves to measure the efficiency of the company’s operational and financial management.
This financial statement starts from the most general (which are billing or sales) until the last result of the business, which is the “net” profit, result or income.
The general presentation of an income statement is more or less as follows:
Billing
(-) Discounts and returns
= Sales revenue
(-) Direct costs
= Gross profit or result
(-) Administrative and sales expenses
(-) Depreciation and amortization expenses
= UAII. = Operating income
(+) Depreciation expenses
= EBITDA
(-) Depreciation expense
(-) Interest on credits
(+) Non-operating income
(-) Non-operating expenses or expenses
= Taxable Income (UAI)
(-) Taxes
= Net income or result.
Fixed costs
They are all those monetary disbursements typical of the normal course of business that is not affected by changes in the levels of operations or sales.
In theory, under a certain fixed investment threshold, sales can double or zero so that fixed costs will remain the same.
A classic example of fixed cost is rent, regardless of whether you make good sales or not month by month, you must pay the rent of the premises.
The difference between fixed costs and variable costs, examples of fixed costs:
- Insurance or insurance premiums
- Professional fees
- Mortgage payment
- Administrative and security staff salary
- Contributions
- Maintenance and cleaning of facilities
- Executive salaries
- Professional fees
Fixed costs directly affect the “operating lever”, since the unit fixed cost will be lower as production and sales volumes increase.
In other words, the more fixed costs you have, the greater the operating leverage.
Thus, once a “breakeven point” has been exceeded, the higher the sales, a leveraged company will experience a greater impact on profit as a result of the increase in income than one with less leverage.
However, fixed costs can be a “double-edged sword”, since the more fixed costs, the greater the pressure or the sales target required to achieve an equilibrium point.
Variable costs
On the opposite side of fixed costs are variable costs. These are all those outflows or expenditures of money that are highly impacted by changes in sales or billing levels.
The more you produce, the more labour you will have to pay, the more inputs or raw materials you will have to buy, you will spend more energy and more packaging material; you will pay more for transportation or parcels …
In short, variable costs go in the same direction as production and sales levels.
Part of financial management is managing fixed or variable costs transforming them to convenience to achieve a greater benefit for the business.
For example, a variable cost can be converted to a fixed cost by the figure of subcontracting or leasing.
Tax shield
Another key concept in understanding leverage (especially financial leverage) is the fiscal shield.
Expansión summarizes the concept of the fiscal shield as “the scheme conceived with the aim of reducing taxes through tax relief”
So we generate a tax shield when we have items that deduct from income tax.
The payment of dividends for preferred shares, interest on loans or bond issues, depreciation of machinery and amortization of intangibles are examples of items that deduct tax or “tax relief”.
The higher the deductions, the greater the tax deduction, because they will result in a lower taxable income and with it a lower tax payment.
The higher the tax shield, the higher the financial leverage of the company.
The “financial lever” is also a double-edged sword, since indebtedness and other capital charges are acceptable up to a certain degree or up to a threshold known as “Leverage”, in which the risk of insolvency takes considerable or high levels.
EPS or earnings per share
EPS is the acronym in English for “ Earnings Per Share ” or earnings per share, is what we get by taking the final result or net profit, which corresponds to the last item in the income statement and divides it by the total shares of the company.
Financial management always seeks to generate the maximum value of EPS to the satisfaction of shareholders and investors.
Having reviewed the concepts used in leverage, we can continue with better footing on the subject.
What does the term leverage mean?
So far it is clear that leverage is leveraging and there may be a financial lever and an operating lever; We will also have combined or mixed leverage.
The renowned author of texts in finance and professor at San Diego State University, Lawrence J Gitman, defines the term leverage in finance as:
“The ability of a company’s board to manoeuvre fixed financial and operating charges thereby seeking to maximize the effects on changes in profit before taxes.”
Items such as fixed costs, interest payments on bonds issued, debt, interest on loans, are key in the application of leverage since they generate a favourable impact on profit in the face of an increase in income.
However, they increase the risk of significantly affecting the result if the income decreases or the operation of the business falls.
