On the basis of nature of risk associated with the investing and financing activities of a firm, leverage can be divided or classified as follow:
1. Operating Leverage
Operating leverage may be defined as the firm's ability to use fixed operating costs to magnify the effect of changes in sales on its earning before interest and tax. The relationship between contribution margin and earning before interest and tax (EBIT) is called degree of operating leverage. It may be defined as the rate of changes in EBIT due to the change in the rate of sales. The firm operating with high fixed operating cost has higher degree of operating leverage. Higher levels of risk are attached to higher degree of leverage. High operating leverage is good when sales are increasing and bad when they are falling.
Operating leverage is used to measure the business risk. Business risk is the risk of the firm not being able to cover its fixed operating costs.
2. Financial Leverage
Financial leverage is related with the financing activities of a firm. The fixed return sources of capital influence the earning of variable return sources. The effect is known as financial leverage.
The use of fixed charge capital is known as financial leverage. If there is no fixed charge capital, there is no financial leverage. The proper utilization of fixed charged capital like debentures, bonds, bank loan and preference share capital is measured by financial leverage. The firm having more debt capital and preference share capital in its capital structure has higher degree of financial leverage and greater amount of risk.
Financial leverage is used to measure the financial risk. Financial risk refers to the risk of the firm not being able to cover its fixed financial costs.
3. Combined Leverage
The combination of operating leverage and financial leverage is called total leverage or combined leverage. Operating leverage measures operating risk whereas financial leverage measures financial risks. Total leverage or combined leverage measures total risk of the business.
Operating leverage is measured by the percentage change in earning before interest and tax due to percentage change in sales where as financial leverage is measured by percentage change in earning per share due to percentage change in earning before interest and tax.
