In finance, leverage (which is also called gearing or levering) refers to the use of debt rather than equity as a source of capital to finance investments and reinvestments. The more debt the business uses the more leverage it has.
As leverage increases, the risks also increase and so does the return on investment. However, as leverage decreases, the risks also decrease as well as the return on investment. Management have almost total control over the risk introduced by increased leverage.
There are three types of leverage:
- Operating leverage – refers to the relationship between sales revenue and operating profit (which is also called EBIT (earnings before interest and taxes))
- Financial leverage – refers to the relationship between operating profit and EPS (earnings per share)
- Combined or total leverage – refers to the relationship between sales revenue and EPS
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