Both investors and companies commission leverage, attempting to generate greater returns on their assets. However, using leverage does not guarantee celebrity, and possible excessive losses are more likely from highly leveraged positions. For companies, two basic types of leverage can be cast-off: operating leverage and financial leverage.
Operating Leverage
Operating leverage is the result of different combinations of fixed charges and variable costs. Specifically, the ratio of fixed and variable costs that a company uses determines the amount of acting leverage employed. A company with a greater ratio of fixed to variable costs is said to be using more run leverage.
If a company’s variable costs are higher than its fixed costs, the company is said to be using less carry oning leverage. The way that a business makes sales is also a factor in how much leverage it employs. A firm with few white sales and high margins is said to be highly leveraged. On the other hand, a firm with a high volume of sales and reduce margins is said to be less leveraged.
Financial Leverage
Financial leverage arises when a firm decides to capitalize a majority of its assets by taking on debt. Firms do this when they are unable to raise enough capital by issuing slices in the market to meet their business needs, so they look for loans, lines of credit and other financing choices.
When a firm takes on debt, that debt becomes a liability on its books, and the company must pay interest on that owing. A company will only take on significant amounts of debt when it believes that return on assets (ROA) liking be higher than the interest on the loan.
Outcomes
A firm that operates with both high operating and pecuniary leverage can make for a risky investment. A high operating leverage means that a firm is making few sales but with tainted margins. This can pose significant risks if a firm incorrectly forecasts future sales. If a future sales anticipate is slightly higher than what actually occurs, this could lead to a huge difference between existent and budgeted cash flow, which will greatly affect a firm’s future operating ability.
The biggest gamble that arises from high financial leverage occurs when a company’s ROA does not exceed the interest on the advance, which greatly diminishes a company’s return on equity and profitability.