Leverage refers to the use of borrowed funds to increase the potential return on investment. Two common types of leverage are financial and operating leverage.
Financial leverage involves borrowing money to invest in assets with the potential for higher returns than the cost of borrowing. This can be done by issuing bonds or taking out loans. By using financial leverage, a company can increase its return on equity (ROE) and potentially boost shareholder value.
However, financial leverage also comes with risks. If the investments do not perform as expected, the company may have trouble repaying its debts and could face bankruptcy.
Operating leverage refers to the use of fixed costs, such as salaries or rent, to increase profitability. By having a high proportion of fixed costs in relation to variable costs, a company can generate higher profits when sales increase.
For example, a manufacturing company that invests heavily in machinery will have high fixed costs but low variable costs. If demand for their products increases, they can produce more units without significantly increasing their expenses. This results in higher profits and a better return on investment.
However, operating leverage also has risks. If demand for the product decreases, the company may still have to pay fixed costs but will generate less revenue. This can lead to losses and reduced profitability.
In summary :
both financial and operating leverage can be useful tools for companies looking to increase their returns on investment. However, they also come with risks that need to be carefully managed.