Leverage Effect Measures

It results from borrowing capital to fund a company’s expansion of its asset base and create returns on risk capital

Author: Manu Lakshmanan
Manu Lakshmanan
Manu Lakshmanan
Management Consulting | Strategy & Operations

Prior to accepting a position as the Director of Operations Strategy at DJO Global, Manu was a management consultant with McKinsey & Company in Houston. He served clients, including presenting directly to C-level executives, in digital, strategy, M&A, and operations projects.

Manu holds a PHD in Biomedical Engineering from Duke University and a BA in Physics from Cornell University.

Reviewed By: Christopher Haynes
Christopher Haynes
Christopher Haynes
Asset Management | Investment Banking

Chris currently works as an investment associate with Ascension Ventures, a strategic healthcare venture fund that invests on behalf of thirteen of the nation's leading health systems with $88 billion in combined operating revenue. Previously, Chris served as an investment analyst with New Holland Capital, a hedge fund-of-funds asset management firm with $20 billion under management, and as an investment banking analyst in SunTrust Robinson Humphrey's Financial Sponsor Group.

Chris graduated Magna Cum Laude from the University of Florida with a Bachelor of Arts in Economics and earned a Master of Finance (MSF) from the Olin School of Business at Washington University in St. Louis.

Last Updated:October 23, 2023

What are Leverage Effect Measures?

Leverage effect measures is the leverage or gearing results from borrowing capital to fund a company's asset base expansion and create risk capital returns. 

Leverage is a strategy of investment that uses borrowed money to raise the projected return of an investment. The term leverage can also be used in reference to the amount of debt a company uses to finance its assets. 

If a company, property, or investment is considered "highly leveraged," it means more debt than equity. Investors use leverage to increase their investment returns through options, futures, and margin accounts. 

For companies, using leverage is an alternative to issuing stock to raise capital. It is often used to raise shareholder value. 

Let us take an example of leverage. Company X was formed with a $10 million investment from investors, where the equity in the company is $10 million. If Company X decides to use debt financing by borrowing $30 million, it now has $40 million to invest in business operations and a greater opportunity to increase shareholder value. 

A water bottle company, for example, could use the borrowed money to build a new factory. This new factor would allow the water bottle company to increase the number of water bottles it can produce and thus increase its profits. 

Key Takeaways

  • Leverage effect measures assess the impact of borrowing on a company's returns and risk. Leverage involves using borrowed money to potentially amplify investment returns.
  • There are three main types: Operational Leverage (impact on operating income), Financial Leverage (sensitivity of net income due to debt), and Total Leverage (combination of operational and financial leverage).
  • Operational Leverage Effect measures how changes in sales affect operating income. Companies with higher fixed costs relative to variable costs are considered operationally leveraged.
  • Financial Leverage Effect quantifies a company's sensitivity to net income changes based on operating income. Higher FLE means earnings are more volatile due to debt obligations.
  • Total Leverage Effect combines operational and financial leverage, offering a holistic view of a company's business risk. It helps assess a company's optimal balance between operating and financial leverage.

Understanding leverage effect measures

The effect of leverage represents the impact of debt on a company's return on equity. Sometimes, more debt can increase a company's return on equity. The measure's primary purpose is to assess the business risk organization.

Business risk refers to the risk arising from variance in revenues and the sensitivity in net income concerning changes in revenues. However, this is only the case if the total return on the investment is greater than the cost of the additional debt. 

The measures aim to quantify the business risk a given firm faces. Business risk is the variance in revenue that a company predicts and the sensitivity of net income to changes in revenue. 

These measures are also designed to represent the impact of a company's fixed and variable costs on its profitability when revenue changes occur. A favorable leverage effect arises when a company borrows funds and uses them to invest at a higher interest rate than the borrowed one. 

There are three types: 

  1. Operational Leverage Effect (OLE)
  2. Financial Leverage Effect (FLE)
  3. Total Leverage Effect (TLE) 

The main factors affecting leverage ratios are debt, equity, assets, and interest expenses. In addition, leverage ratios can measure a firm's breakdown of operating expenses to see how a change in output might affect the company's operating income

Operational leverage effect measure

Operating leverage measures how much a company can increase its operating income by increasing revenue. A company has high operating leverage if it can generate sales with a high gross margin and maintain low variable costs. 

The operational leverage effect measure estimates how changes in ROA (return on assets) and net income are correlated with changes in sales volume. 

Return on assets is a financial ratio that measures a company's profitability in relation to its total assets. This ratio analyzes a company's efficiency in using its assets to generate profit. 

Using this measure is helpful for companies with relatively high fixed costs and experience quite a bit of revenue variance. 

A company with a lot of fixed costs, in comparison to variable costs, will have a higher level of operating leverage. If a company has a high proportion of fixed costs, a significant increase in sales can result in substantial changes in profits. 

The formula for calculating is as follows:

OLE = (% change in operating income) / (% change in sales)

A company is considered operationally leveraged if its OLE is greater than 1. That is with the fixed costs. It means that fixed costs in the operations are higher than variable costs.

On the other hand, if a company's OLE is precisely 1, all costs incurred are variable, meaning that a change in sales would cause a proportional change in ROA. 

Financial leverage effect measure 

As opposed to purely equity-financed companies, firms that use debt in their capital structure take on more business risk. Companies that use debt must make regular interest payments to their lenders, causing them to be more operationally leveraged. 

Being obligated to make these interest payments means companies have a constant cash outflow that can hinder their profitability. In addition, if a company takes on more debt, it is more likely to default on its loans. Thus, investors consider companies that finance using a lot of debt riskier. 

The formula for calculating the is as follows:

FLE = (% change in net income) / (% change in operating income)

This ratio quantifies a company's sensitivity to net income to operating income

The difference between operating and net income is a company's interest payments, taxes, depreciation, and amortization, which are all highly contingent on the company's capital structure.

The goal of FLE is to measure the degree of financial leverage a company experiences based on the company's capital structure. It represents a company's EPS sensitivity to changes in its operating income. 

If a company's FLE is 1.5, an increase in operating income of 10% will increase its net income by 15%. A higher degree of financial leverage means that earnings will be more volatile. 

Total leverage effect measure

This last measure combines the operating leverage effect and the financial leverage effect. The equation for TLE is as follows:

TLE = FLE * OLE

The total leverage effect measure aims to aggregate the FLE and OLE into one quantity that accounts for a company's overall leverage state. 

The TLE considers all the operational and financial leverage a company experiences and determines the company's overall business risk. 

Another way to understand a company's degree of total leverage is through earnings per share (EPS). The ratio compares a company's rate of change in EPS to its rate of change in revenue from sales. 

Calculating a company's degree of total leverage helps establish the type or amount of change it can anticipate in its EPS in relation to an increase in sales revenue. Analyzing these changes in EPS allows a company's management to assess its performance because it can see the income the company is generating for its shareholders. 

The total leverage effect is useful for determining a company's optimal operating and financial leverage.

Note

The degree of total leverage (DTL) is also sometimes referred to as the degree of combined leverage (DOL).

Researched and authored by Rachel Kim | LinkedIn

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