According to finance, gearing or leverage refers to utilizing a particular amount of resources in such a manner that the expected negative or positive outcome is amplified. It commonly denotes the usage of debts or borrowed funds in an effort to enhance the yield from equity.
Leverage can be categorized into the following types:
Financial Leverage
Financial leverage is available in different forms of debt (borrowings) or loans. The returns or yields from these loans are again invested with the aim to receive a higher rate of yield in comparison to the interest cost or interest expense. In case the return on assets or ROA is more than the interest payable for the loan, the ROE or return on equity would be more if the loan had not been taken.
On the contrary, if the returns on assets were less than the rate of interest, then the return on equity would be less than the case where the debt had not been taken. With the help of leverage, the investor has higher potential of return in comparison to other available options. Nevertheless, the possibility of loss is also higher simply due to the reason that if the investment gets valueless, the outstanding amount of interest of the loan and the principal amount of the loan yet have to be paid off.
Margin buying is a basic method of using the idea of leverage in investments. An all-equity firm may be considered as an unlevered firm and on the other hand, a levered firm comprises of debt and ownership equity. The debt to equity ratio of a firm (which is calculated at book value or market value, according to the intention of the analysis) is hence a denotation of its leverage. The Modigliani-Miller theorem explains the impact of the debt to equity ratio on the firm's value. Similar to operating leverage, the level of financial leverage calculates the consequence of a variation in one variable quantity upon another variable quantity. DFL or degree of financial leverage can be delineated as the percentage variation in income or earnings per share that happens as an effect of a percentage variation in income before taxes and interest.
The different measurements of financial leverage are the following:
1) Debt to Equity Ratio
The measurement of debt to equity ratio is usually done by dividing the total liabilities of a firm (excepting equity of the shareholder) with the shareholder's equity. It is expressed by the following formula:
Debt to equity ratio = D/E
Here E refers to shareholder's equity and D refers to the liabilities.
The debt to value ratio is expressed by the following formula:
Debt to value ratio = D/D+E
2) Du Pont Analysis and Gearing
The application of Du Pont identity necessitates that leverage is calculated by dividing the total assets with shareholder's equity (this is more broken down in the conventional analysis) and in some instances, this is just termed as leverage or gearing.
Gearing or Leverage = A/E
Here A refers to total assets and E refers to shareholder's equity.
Operating Leverage
Operating leverage demonstrates the degree to which the fixed assets and related fixed expenditure are used in a commercial enterprise. DOL or degree of operating leverage can be termed as the percentage variation in operating income that happens as a consequence of a percentage variation in the number of units sold.
Correlation Leverage
Under this idea, correlation leverage appropriates the level to which the variance in the revenue of the firm is reciprocated therewith to other firms. The measurement method utilized is called as beta co-efficient.
Combined Stand-alone Leverage
In case both financial leverage and operating leverage permit the investors to amplify their returns, then they have the option of receiving the maximal leverage with the help of their consolidated usage and this is known as combined leverage.
Derivatives
The derivatives permit leverages free of borrowing in an explicit manner, however, the result of borrowing is implied in the derivative cost. Examples of such transactions are options, futures contract, and structured products.