Leverage

Leverage refers to using borrowed money or fixed-cost resources to increase the potential return on an investment. It helps businesses and investors earn higher profits by using external funds, but it also increases risk because losses can grow if the investment performs poorly. Leverage can be financial (using debt), operating (using fixed costs), or a combination of both.

Types of Leverage:

Financial Leverage: Use of debt to finance assets, aiming to increase returns to shareholders.

Operating Leverage: Use of fixed costs in operations to magnify profits with increasing sales. Combined Leverage: The combined effect of operating and financial leverage on earnings.

Risk Factor: Higher leverage increases financial risk; if returns on investment are lower than the cost of borrowing, losses are magnified.

Example: A company invests ₹1 crore of its own capital and borrows ₹4 crore at an interest rate of 8% to purchase equipment. If the equipment generates a 15% return on total investment, the profit attributable to the company’s equity is higher than it would have been without borrowing, demonstrating the effect of financial leverage