Answer
Leverage is the existence of fixed costs among a firms cost. It is useful to categorize leverage as operating and financial.
Operating leveraging arises when there are fixed operating costs in the firm's structure. Fixed operating costs such as administrative costs, depreciation, advertising expenditures and property taxes but do not include debt interest. With positive fixed operating costs, a change of 1 percent in sales produces more than a 1 percent change in EBIT. A measure of this effect is referred to as the degree of operating leverage (DOL) and it equals:
Degree of operating Leverage (DOL) = (Percentage change in EBIT)/(Percentage change in units sold).
The greater is a firm's DOL, the more its EBIT will vary with sales fluctionns.
The financial leverage arises when a company borrows funds. A firm with no debt has no financial leverage. A change of 1 percent in EBIT produces more than a 1 percent change in EPS. The greater is the firm's debt, the greater will net after tax earmning, per share hange due to a given change in EBIT. A measure of this effect is referred to as the degree of financial leverage (DFL) and it equals:
Degree of Financial Leverage (DFL) =(Percentage change in EPS)/(Percentage change in EBIT).
The degree of financial leverage (DFL) increases directly with increased borrowing.