Financial and Operating Leverages

Financial and Operating Leverages

Introduction

In a globalized world, where everyday consumers have access to much amount of goods and services, forcing companies to devise strategies that make competitive.

Among the functions of Finance is the determination of investments and how they will finance. The latter can be obtained from various forms. The best combination of them will enable the achievement of the goal of Financial Management, i.e., maximize the value of the company. One of the tools used to analyze the use of costs that incurred by the company's leverage.

By using the term leverage in finance, refers to Use of fixed costs and charges to which a variation has sales a greater range of variation in profitability. The use of leverage brings higher performance and greater risk, understood the latter, as the company's ability to cover its fixed costs. Therefore an increased use of leverage will result in greater profitability and increased risk less use of it will bring the opposite effect. The three types leverage that exists are: operational, financial and total.

The first has to do with the ability of the company to use the fixed operating costs for maximizing the effects of changes in the sales on EBIT. Moreover, the gearing and the ability Company to use fixed financial charges to increase the maximize the impact of changes in EBIT on the EPS. Finally, the Total leverage is the product of operating and financial leverage, or could be defined as the ability of the Company to use the costs and charges fixed, maximizing the effect of changes in sales.

Leverage

It is the ability of the Company to use assets or funds of fixed costs in order to maximize profit for shareholders.

Leverage affects

Performance: increase the income available to shareholders.

Risk: uncertainty associated with the company's ability to cover fixed payment obligations.

Types of Leverage

Operating Leverage

It is the relationship between income sale of the company and its profits or earnings before interest and taxes (EBIT)

Financial Leverage

Is the relationship between the Utilities or earnings before interest and taxes (EBIT) and the Gain Available to common stockholders and earnings per share.

Total Leverage

Is the combined effect of the two (2) leverage above.

Leverage Ratios

Leverage ratios, which measure the contributions of owners compared with funding provided by the creditors of the company, have some consequences.

First, examine the equity or funds provided by the owners, to seek a margin of safety. If the owners have provided only a small proportion of total funding. The risks of the company are mainly made by creditors. Second, raising funds through debt, the owners get the benefits of maintaining control of the company with a limited investment. Third, if the company earns more borrowed funds than they pay interest, the utility of entrepreneurs is higher.

In the first case, when the asset earns more than the cost of debt, leverage is favorable, the second is unfavorable. Firms with low leverage ratios are less likely to lose when the economy is in a recession, but are also lower expected ...