Leverage refers to using borrowed funds or debt to amplify potential returns or risks in an investment. It's a strategic tool where individuals or businesses aim to increase their exposure to assets or markets beyond their available capital. While it can magnify gains, leverage also intensifies losses, as both profits and losses are calculated based on the total investment, not just the initial capital. 

Balancing leverage involves assessing risk, as higher leverage increases the potential for significant gains or losses, emphasising the importance of prudent risk management in financial decision-making.

Important Types of Leverage

Financial Leverage: This involves using borrowed funds to increase the potential return on investment. For example, a business may utilise debt to fund operations or growth to outpace the cost of borrowing.

Operating Leverage: This type of leverage is about using fixed costs, like rent or salaries, to increase the profitability of a business. When a company has high fixed costs and sales increase, the incremental revenue contributes significantly to the bottom line due to these fixed costs remaining constant.

Formula

In finance, leverage can be calculated in various ways depending on the context. One common formula used to calculate leverage in a financial context is the debt-to-equity ratio.

The formula for the debt-to-equity ratio is:

Debt-to-Equity Ratio = Total Liabilities / Shareholders’ Equity

Where:

Total Liabilities refer to the total debt obligations or liabilities of a company

Shareholders' Equity represents the difference between a company's assets and liabilities, reflecting the portion of the company owned by its shareholders

Another form of leverage calculation involves the equity multiplier:

Equity Multiplier = Total Assets  / Shareholders’ Equity

This ratio measures the proportion of a company's assets financed by shareholders' equity versus debt. A higher equity multiplier signifies higher financial leverage and greater reliance on debt financing. Further, we can use the formula for operating leverage.

Operating Leverage = Percentage Change in EBIT / Percentage Change in Sales

Examples

Let's consider three examples in an Indian context to illustrate these financial ratios:

Debt-to-Equity Ratio:

Company A has a total debt of Rs. 50,00,000 and shareholders' equity of Rs. 1,00,00,000. 

Debt-to-Equity Ratio = Total Liabilities / Shareholders’ Equity

Debt-to-Equity Ratio = Rs. 50,00,000/ Rs. 1,00,00,000

Debt-to-Equity Ratio = 0.5

This means that for every Rs. 1 of shareholder's equity, Company A has Rs. 0.5 in debt. A lower ratio typically signifies lower financial risk.

Equity Multiplier:

Company B's total assets amount to Rs. 1,50,00,000 and shareholders' equity is Rs. 50,00,000. 

Equity Multiplier = Total Assets/Shareholders’ Equity

Equity Multiplier = Rs.1,50,00,000/Rs. 50,00,000

Equity Multiplier​ = 3

This indicates that Company B's assets are three times its shareholders' equity, implying that a significant portion of the assets is funded through debt.

Operating Leverage:

Company C has a contribution margin of Rs. 80,00,000 and EBIT (Earnings Before Interest and Taxes) of Rs. 40,00,000. 

Operating Leverage = Contribution Margin/EBIT

Operating Leverage = Rs. 80,00,000/Rs. 40,00,000

Operating Leverage= ​ 2

This implies that for every percentage change in sales, Company C's EBIT will change by two times that percentage. Higher operating leverage indicates a higher sensitivity of earnings to changes in sales.