What is the Importance of Leverage in Accounting?

Leverages are the tools used by the financial experts to measure the return to the owners. The financial leverage is considered to be superior of these tools. Financial leverage focuses the attention on the market price of the share. The management of a company always tries to increase the market price of the shares by increasing the net worth of the company. Therefore, the management resorts to trading on equity in order to increase EBIT and then the corresponding increase in the price of the equity shares.

A company has to keep the balance between the two leverages because they have got tremendous effect on EBIT and EPS. A right combination between the two leverages is a very big challenge for the company managements. A proper combination of both operating and financial leverages is a blessing for the company’s growth. However, an improper combination may prove to be a curse. Financial or operating leverages exist only when the result of the calculation is more than one.

A high degree of operating leverage together with a high degree of financial leverage makes the position of the company very risky. In this case, a company employs excessively assets for which it has to pay fixed costs and at the same time it uses a large amount of debt capital. The fixed costs for using assets and fixed interest charges bring a greater risk to the company. If the earnings fail, the company may not be in a position to meet its fixed costs. Greater fluctuations in earnings are likely to occur on account of the existence of a high degree of operating leverage. The existence of high degree of operating leverage will result in a more than proportionate change in operating profits even on account of small change in sales. The presence of a high degree of financial leverage causes more than proportionate changes in EPS even on account of a small change in EBIT. Thus, a company having a high degree of financial leverage and a high degree of operating leverage has to face the problems of inadequate liquidity or even insolvency in one or the other way. However, lower leverages indicate the cautious policy of the management but the firm may be losing many profit-earning opportunities. Therefore, a company should make all possible efforts to combine the operating and financial leverage in a way that suits the risk-bearing capacity of the company. Thus, a company with high operating leverage should have low financial leverage so that the combined leverage may be ideal. Similarly, a company having a low operating leverage will stand to gain by having a high financial leverage provided it has enough profitable opportunities for the employment of borrowed funds. Low operating leverage and a low financial leverage is considered to be an ideal situation for the maximization of the profits with minimum of risk.

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