Leverage, in finance, is about magnification — like a physical lever, a small input (change in sales) produces a larger output (change in profit or EPS). Before making any capital structure decision, you must know how sensitive your profits and earnings are to changes in sales. That sensitivity is what leverage measures.
Operating Leverage (OL) captures how a change in Sales affects EBIT. It arises purely from fixed operating costs — rent, depreciation, factory overheads. The formula is: OL = Contribution ÷ EBIT, where Contribution = Sales − Variable Costs. If OL = 3, a 10% rise in sales produces a 30% rise in EBIT. High fixed costs → high OL → high business risk. Think of a steel plant with heavy depreciation versus a trading firm with mostly variable costs.
Financial Leverage (FL) captures how a change in EBIT affects EPS. It arises from fixed financial charges — interest on debt. Formula: FL = EBIT ÷ (EBIT − Interest). If the company also has preference shares, the denominator becomes: EBIT − Interest − [Preference Dividend ÷ (1 − Tax Rate)] — because preference dividends are paid from after-tax profits. FL = 2 means a 10% rise in EBIT gives a 20% jump in EPS — great in good times, painful in downturns.
Combined Leverage (CL) = OL × FL = Contribution ÷ EBT (where EBT = EBIT − Interest). This single number tells you: if sales go up by 10%, EPS will go up by CL × 10%. It is the total risk multiplier. A CL of 4 in a cyclical business is dangerous; the same CL in a stable FMCG firm might be perfectly manageable. The ICAI consistently tests CL in 4-mark and 8-mark questions — usually by giving you an income statement and asking for all three leverages, or by asking what happens to EPS when sales change by a given percentage. Always cross-check your CL using the direct formula; if OL × FL ≠ Contribution ÷ EBT, you have an arithmetic error somewhere.