## Introduction to Leverage

### Why Leverage Matters

The objective of financial management is to maximise wealth (market value).

Value is directly related to company performance
Value is inversely related to investor expectations (risk)
Risk drives those expectations → managing risk = managing leverage

### Two Types of Risk

Risk	What It Is
Business Risk	Risk from operations; uncertainty in EBIT (how stable are operating profits?)
Financial Risk	Additional risk to shareholders arising from use of debt in the capital structure

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### Meaning of Leverage

Leverage = the influence or power of one financial variable over another related variable.

Formula: `Leverage = % Change in Y / % Change in X`

The financial variables involved:

Costs, Output, Sales/Revenue, EBIT, EPS

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### Three Types of Leverage

Leverage	Relationship	Risk Captured
Operating Leverage (OL)	Sales → EBIT	Business Risk
Financial Leverage (FL)	EBIT → EPS	Financial Risk
Combined Leverage (CL)	Sales → EPS	Total Risk

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### Business Risk vs Financial Risk (Detailed)

Basis	Business Risk	Financial Risk
Meaning	Risk of not covering operating costs	Risk to equity shareholders from fixed-cost funds
Cause	Uncertainty in EBIT	Fixed financial charges (interest, preference dividend)
Factors	Demand variability, sales price, input costs	Amount of debt and preference capital in structure
Measured By	Operating Leverage (OL)	Financial Leverage (FL)
Impact On	EBIT	EPS

Worked example

### Example 1

Identifying Risk Type:

A steel manufacturer has high fixed costs (blast furnaces, salaries). A 10% drop in sales revenue causes EBIT to drop 25%. This amplification is Business Risk, measured by Operating Leverage.

The same company also has ₹50 crore in bonds at 12% interest. When EBIT drops, interest must still be paid — this additional squeeze on equity earnings is Financial Risk, measured by Financial Leverage.

### Example 2

Leverage Formula:

If sales increase by 5% and EBIT increases by 15%, the Operating Leverage = 15% / 5% = 3. This means for every 1% change in sales, EBIT changes by 3% — the firm has high business risk.

⚠️ Common exam mistakes

Mixing up business risk and financial risk — business risk is about operations (EBIT volatility); financial risk is about capital structure (EPS volatility due to fixed financial charges).
Thinking operating leverage measures financial risk — OL measures business risk; FL measures financial risk.
Forgetting that preference dividends are fixed financial charges and contribute to financial leverage/risk, just like interest on debt.

Reference:

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Introduction to Leverage – Types and Business vs Financial Risk

Worked example

⚠️ Common exam mistakes