The common meaning of leverage is the effect of one variable on another variable. If financial accounting, leverage is used to measure the risk i.e. the effect of changes in revenue and costs on the shareholders return. If the leverage is high, a small percentage increase or decrease in revenue (sales) results too much increase or decrease in the shareholders return or earning per share. If the leverage is low, the return changes slightly despite a high increase or decrease in the sales.
The capital of a company can be collected from various sources of financing whose costs are different. Sources of capital can be divided into two types i.e. fixed return and variable return sources of capital.Fixed return sources of capital include debentures, bonds, bank loan and preference share capital, whose return is fixed. Variable return sources of capital include equity share capital whose return is variable because they receive the residual income. The fixed return sources of capital influence the return of variable sources of capital and such effect is known as leverage.
In this way, equity shareholders are the owner of a company and their return is affected by the investing and financing activities of a company. The purchase of fixed assets increases the fixed operating cost. Similarly, the issues of debentures and preference shares increases the fixed financial cost (interest and dividend). Leverage is a mechanism of measuring the possible effect of investing and financing activities on the earning available to shareholders.
