## Leverages: Introduction and Core Concepts

### Why Study Leverage?

The objective of financial management is to maximise firm value (wealth). Value depends on:

Company performance → directly related to value.
Investor expectations → inversely related (higher expected risk → lower value).
Risk → the link between performance and expectations.

### Meaning of Leverage

Leverage represents the influence or power of one financial variable over another related variable. Mathematically:

```

Leverage = % Change in Output Variable / % Change in Input Variable

```

The financial variables involved can be: Costs, Output, Sales/Revenue, EBIT, EPS.

### The Three Types of Leverage

### Business Risk vs Financial Risk

Basis	Business Risk	Financial Risk
Meaning	Risk of not covering operating costs	Risk to equity holders from fixed-cost funds
Cause	Uncertainty in EBIT	Fixed interest + preference dividend obligations
Factors	Demand variability, price changes, input costs	Proportion of debt + preference capital
Measured by	Degree of Operating Leverage (DOL)	Degree of Financial Leverage (DFL)
Impact on	EBIT	EPS

### Operating Risk vs Financial Risk

Basis	Operating Risk	Financial Risk
Meaning	Risk of not covering fixed operating costs	Risk of not meeting fixed financial charges
Cause	Fixed operating costs (rent, salaries, depreciation)	Fixed financial costs (interest, pref. dividend)
Impact	Variability in EBIT	Variability in EPS
Higher level means	EBIT is highly sensitive to sales changes	EPS is highly sensitive to EBIT changes

Worked example

### Example 1

Understanding Leverage as Influence:

Firm has: Fixed Costs = ₹10 lakh, Variable Cost = 60% of sales.

Operating Leverage = 40% / 20% = 2

A 20% increase in Sales caused a 40% increase in EBIT → Fixed operating costs amplified the impact. This is Business Risk in action.

⚠️ Common exam mistakes

Confusing business risk with financial risk — business risk is about operating performance (EBIT), financial risk is about how EBIT is then split between debt holders and equity holders (EPS).
Thinking operating leverage = financial leverage — they are completely different (OL relates Sales to EBIT; FL relates EBIT to EPS).
Using 'leverage' loosely to mean only financial (debt) leverage — operating leverage from fixed operating costs is equally important.

Reference:

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Introduction to Leverages: Meaning, Types, Business Risk vs Financial Risk

Worked example