DEFINITION of 'Leverage' 1. The use of various financial instruments or borrowed capital, such as margin, to increase the potential return of an investment. 2. The amount of debt used to finance a firm's assets. A firm with significantly more debt than equity is considered to be highly leveraged. Leverage is most commonly used in real estate transactions through the use of mortgages to purchase a home.

1. FINANCIAL LEVERAGE AND
CAPITAL STRUCTURE

2. LEVERAGE
 ‘Leverage’ means ‘effectiveness’ or ‘power’.
 A firm is said to be leveraged if it has fixed costs.
 There are three types of leverage:
- Operating leverage – fixed costs associated with running the firm.
- Financial leverage – fixed costs associated with financing the firm.
- Combined leverage – combination of operating and financial leverage.
 Degree of leverage
- Measure of how much leverage the firm uses.

3. FINANCIAL LEVERAGE
 Financial leverage is the use of fixed financial costs to measure the
effects of changes in sales to the firm’s net earnings.
 Sources of financial leverage are primarily debt and preferred stock.

4. MEASURING FIN. LEVERAGE
 Degree of Financial Leverage:
DFL 
 Stylized form:
% Change in Net Earnings
% Change in EBIT
EBIT
 
 

 Note: As DFL increases, volatility in net earnings increases.



 

T
EBIT I PD
DFL
1
(at base EBIT)

5. CAPITAL STRUCTURE
 The mix of long-term financial sources used to finance the firm.
 It usually refers to the specific proportions of debt, equity, preferred stock,
etc. used to finance the firm.
 Only long-term sources are included.