Impact of Leverage on Risk and Return

When we take decision of producing the products and making capital structure, we check the impact of leverage on risk risk and return. In finance, leverage is best technique to increase return at very low risk, if we have understood the impact of leverage on risk and return.

If we study the physical science, we know that we can lift heavy weight by using the support of small wood backside of wood stick. With small leverage power, our energy will multiply 10 times of heavy weight. Now, what will happen, we lift the weight more easily.

1st : See the Impact of Operating Leverage on Risk and Return

To check this impact, we have to calculate operating leverage. Operating leverage is % change of earning before interest and tax divided by % change in sales. If it is 2/1 it means it is low, we have increased 1% of our sale but our earning has increased 2%. But if there is situation of 5/1. It is high operating but more from this may be risky because at that time our current ratio will not be according to rule of thumb.

2nd : See the Impact of Financial Leverage on Risk and Return 

We will also see the impact of financial leverage on risk and return. High financial leverage means we got high loan at low rate of interest and low financial leverage means we has taken loan at high rate of interest. We can calculate financial leverage by taking percentage of changing in earning per share and changing in earning before interest and tax. Low and very high financial leverage is not good.

3rd : See Impact of  the Combined  Leverage on Risk and Return 

When we see the impact of the combined leverage on risk and return, we can better insight. High operating and high financial leverage are very risk for business. But low operating and high financial leverage is good combination.

Related : Relationship of Risk and Return