Accounting

Leverage is a measure of using given resources in such a way that the potential positive or negative outcome is magnified ( Leverage (finance ' 2008 . In a firm , this leverage is broken into operating and financial leverage

Operating leverage measures the degree upon which fixed costs is used in a company 's production processes . A higher operating leverage means that a company would be more sensitive to change in sales , since it must pay its fixed costs whatever the amount of revenue it has Consequently , it would benefit from a lower debt ratio because

of this higher business risk . The degree of operating leverage is measured as a the quotient of the percentage change in EBIT and the percentage change in sales

Financial leverage refers to a company 's use of fixed charge securities like debt and stock to increase the return on common stockholders . The degree of financial leverage is measured as the change in EBIT over the change in earnings after interest . With the optimum mix of debt and equity a company can maximize its EPS , but higher debt carries higher risk . Risk is passed on to common stockholders , but a firm that borrows will improve its return on equity

Both are measures of change in one variable on another variable ( Leverage (finance ' 2008 . Their difference lies in the fixed expenses that are behind them - in operating leverage it is the fixed costs of production like depreciation , while financial leverage depends on finance costs like interest expense . However , both are interrelated in management decisions . A reduction in operating leverage would normally lead to an increase in the optimum amount of financial leverage , with the inverse being true

R E F E R E N C E

Leverage (finance (2008 . Wikipedia : The Free Encyclopedia Retrieved April 29

2008 from http /en .wikipedia .org /wiki /Leverage_ 28finance 29

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