Leverage Essay

265 WordsSep 11, 20132 Pages
Operating leverage brings to the foreground the importance of fixed costs relative to variable costs. Firms that have large fixed costs have operating leverage. These firms must achieve a higher level of sales to break even. Firms with costs that fluctuate with the level of output do not have operating leverage; they may achieve profits at a lower level of production. However, once profitable levels of output are achieved, the firm with more operating leverage will experience more rapid increases in operating income for given changes in production. This increased variability of operating income increases the business risk associated with the firm. All assets must be financed. There are two basic sources of finance: debt and equity. If a firm uses debt financing, it is financially leveraged. If the firm is able to earn more with the funds acquired by issuing debt than it must pay in interest, the residual accrues to equity. By successfully using debt financing, the firm increases the owners’ return on their investment. Although the successful use of debt financing increases the return on equity, it also increases financial risk. If the firm experiences a decline in sales or profit margins, it must still pay the interest and retire the principal. Failure to do so may result in bankruptcy. Thus, while the use of debt financing may increase the return on equity during periods of success and growth, the opposite may be true during periods of difficulty. Then the use of debt financing reduces the return on equity, as the firm must meet the fixed obligations of its debt
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