What are the Types of Leverage?

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What are the Types of Leverage?

Registrationwala

Leverage is a concept in finance. It refers to a technique in which borrowed funds are utilized to buy an investment. With the help of the leveraged funds, a company can purchase more assets. The profit generated from the assets can be utilized for debt repayment. If a company has more debt than average for its industry, it is considered a highly leveraged company. In this article, we discuss what are the leverages which can be used by companies.

Types of Leverage

There are three main types of leverage discussed in the finance world, namely, financial leverage, operating leverage, and combined leverage. 

Financial Leverage

Financial leverage is a strategic technique which involves borrowing money to invest it in assets. The goal is to earn a profit on those assets which exceed the cost of borrowing the funds. 

This technique allows companies to increase their profitability without using additional personal capital of the company.

Operating Leverage

Operating leverage is a financial measure which describes the proportion of fixed costs in a company’s cost structure. The fixed cost remains the same for each period, whereas variable costs tend to change due to the change in production rate. 

For example, rent and property taxes are fixed costs that need to be paid by the company each period, and their amount remains the same regardless of production levels. 

Sales commission is an example of a variable cost. Sales increase as an employee sells more products, and so does the company's cost. We get the total cost when all fixed and variable costs are combined.

Combined Leverage

Combined leverage refers to a technique that combines financial and operating leverage to increase potential return on investments. Both debt financing and fixed cost are used in this technique to purchase assets or invest in projects.

An example of combined leverage is when a company rents a factory, hires employees for goods production, and borrows money to buy a new factory in the hope that its debt interest and fixed costs will be offset by revenues that result from leverage use.

How Does Leverage Help a Company?

When a company borrows funds, it has to use less amount from its capital. This increases returns substantially. Suppose a company wants to purchase land worth Rs. 50 lakh and the returns calculated from this land are Rs. 65 lakh. If the company chooses to pay the entire Rs. 50 lakh amount from its account, it’ll earn a return of Rs. 15 lakh. However, if a company chooses to take out a loan of Rs. 40 lakh, then the returns will be turned into Rs. 15 lakh. Leveraging is a powerful tool for companies. The profits from the land will eventually increase with time when the land (asset) becomes more than the loan interest.

Conclusion

Leverage is the practice of borrowing money and using it to make investments. It is an essential concept for investors through which they can evaluate the fundamentals of a company. A company can use the different types of leverage available, namely, financial, operating and combined leverage, based on their requirements. Leveraging borrowed funds can help companies to increase their returns. However, there is also the risk of default and interest payments.

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