Leverage
The term "leverage" means advantage. It is generally believed that fixed costs, whether operational or financial, are a disadvantage to an entity. However, this is not always true. Sometimes, or even often, having fixed costs can prove to be a significant advantage, especially during mild to moderate expansion. With no additional fixed costs, the company can book the entire contribution as profit, which is a substantial benefit, isn’t it? Therefore, one should apply the general rule with greater caution.
Similarly, financial fixed costs increase the financial risk of an entity, both in terms of the income statement and balance sheet analysis. However, this risk can be turned into an advantage when the company makes good profits. Borrowing strength primarily comes from good earnings, rather than the security offered, in most cases. Entities pay the fixed interest while the remaining profits directly increase the net worth of equity shareholders. Hence, nothing is entirely risky nor should be embraced without caution.
By CA L.Muralidharan and CPA L.Mukundan
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