Financial leverage is buying of assets by use of debts. Return on equity is a goal that leverage often aims at achieving. Financial leverage should always not exceed certain limits that could result in the risk of failure due to the accumulation of too much debt that is difficult to repay. Operational leverage, on the other hand, is the measure of a company's operating income through an increase in revenue. Thus, a company's operational leverage can be determined in terms of gross margins and variable costs, such that, with high gross margins, with low variable costs, the operational leverage is usually high.
Financial leverage can be determined by use of debt and assets. Such that, it is taken as the ratio of debt to assets (AccountingTools, 2019). The debt for this case is the total owed debt, and the assets should also be the total assets that the company has bought. The main objective of financial leverage should be to use the debt borrowed to generate returns which should be higher than interest expenses that are involved with the debt. Financial leverage consists of internal financing, which involves the use of funds as acquired from the company's routine activities. Therefore, internal financing does not include borrowing finances from financial institutions neither does it involve borrowing money through equity or debt. Thus, the company involved should be reliable enough in its business and sales to be able to raise funds within its activities rather than borrowing to fund its upcoming projects through funds raised internally.
Financial leverage consists of equity financing, which involves the selling of a company's stock with the aim of raising capital. Often, investors are involved in the buying of the stock from the company. It includes sharing of the company's interests, that is, shareholders are given the ownership during the return on investment. Reduction of dividends is often involved in financial leverage. Often, a company is usually engaged in reducing dividends when problems are affecting its cash flow. These problems can be in the form of decline in profit margins, sales are on the fall, and when the expenses involved becomes too much or start rising. Therefore, this always leads to investors or shareholders selling their shares of the company, which still cause the share price to fall below required limits.
Use of leasing to acquire capital assets is another method involved in financial leverage. It consists of a lessor and a lessee where a lessee is a borrower who selects an asset which can be in the form of anything of interest. The lessor is the finance company who purchases the asset chosen by the lessee. For this case, the lessee will enjoy the asset during the lease period. In contrast, the lessor has the recovery of the asset in large part, and that will earn interest in accordance to the operations put in place by the lessee on the asset (Courses.lumenlearning.com, 2019). Operations may include renting of the asset where the lessor earns interest from.
Operating leverage involves accounting of costs involved in a company's routine activities. A company can use the capital asset pricing model in the estimation of the equity costs, which involves premium risks being added on to the risk-free rate. Cost of capital is determined as per the weighted average of the costs involved and is the return used in budgeting capital for projects of a company. Cost of capital can then be used in the determination of net present values and in discounting of cash flows. However, high degrees of operating leverage can be problematic and can indicate danger as from forecast risk (Investopedia, 2019).
Thus, a small error made in the estimation of sales and predicting of the sales will have a severe effect and impact in cash flow projections. Operating leverage is thus involved and helpful in the calculation and determination of a company's selling prices and break-even points. Therefore, through operating leverage, a company can set forth the most appropriate selling prices that will include all the costs incurred to ensure the generation of profits in its business. Therefore, in an aim to mitigate operational risks, the company should strive at minimizing fixed costs which result in increased earnings without necessarily making adjustments in selling prices.
However, several factors affect the leverage of companies. These factors include opportunities for growth (flexibility of the company), profitability, the size of the company or firm, intangibility and tangibility of the company's assets, and the median leverage of industry involved. Of course, every other company's main objective is towards attaining and achieving high-profit margins. However, this is usually a success when the company has fewer debts and does not involve itself in financing through debts, and that it is able to accumulate its earnings to fund its projects and activities. Thus, any company mustn't adapt itself into too much borrowing if its primary goal is to achieve high margins of profits.
KENTON W, 'How Operating Leverage Works' (Investopedia, 2019) <https://www.investopedia.com/terms/o/operatingleverage.asp> accessed 24 December 2019
'Leasing | Boundless Finance' (Courses.lumenlearning.com, 2019) <https://courses.lumenlearning.com/boundless-finance/chapter/leasing/> accessed 24 December 2019
Bragg S Bragg, 'Financial Leverage - Accountingtools' (AccountingTools, 2019) <https://www.accountingtools.com/articles/2017/5/14/financial-leverage> accessed 24 December 2019
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