Watch this video by your own Finance Guru, Vishal Thakkar, to know about operating leverage & financial leverage in business.
Ladies and gentlemen boys and girls welcome back to finance tube your friend and finance guru vishal tucker is back again with yet another video which talks about leverage what is leverage how does leverage work now typically leverage is a principle from science but we use it in finance leverage was originally discovered by archimedes and archimedes was a scientist
Who was best known for making the statement that give me a place to put my apparatus and i will lift this earth with my two fingers let’s understand what leverage is and how leverage works leverage is a concept where you can achieve more by putting in minimum effort so leverage gives you the efficiency so to give a simple example if you want to draw water from a
Well and if you just throw the bucket down and if you pull upwards since you are pulling against the gravity you will require a lot of efforts to pull the bucket up but if you install a pulley on to the well and if you pull it down if the rope is coming from the pulley and if you pull it down you are pulling towards gravity and the effort required to draw water
From a well gets reduced substantially so this is basically the principle of leverage minimum input leading to maximum output now how does it work in finance in finance there are two types of leverages operating leverage and financial leverage let us understand each one in detail operating leverage is a concept of using your fixed cost to its maximum potential to
Bring down the total cost per unit of a product how does it work let us say you have a factory in which you make t-shirts now the rent of the factory is let’s say five thousand rupees every month you make 1000 t-shirts so what is rent per t-shirt five rupees now from next month onwards you increase your capacity from one thousand to two thousand five hundred how
Much does it come to rent per t-shirt comes to two rupees now you increase your capacity to make five thousand t-shirts next month how much does rent per t-shirt come to one rupee per t-shirt next month you make ten thousand t-shirts fifty paisa after that you make two million t-shirts oh sorry that’s china that can’t happen in india right so point is that if you
Make two million t-shirts every month out of the factory which has a rent of 5,000 rupees you’re rank for t-shirt is so negligible that you can actually bring down the price of the t-shirt substantially now what i what i said is an extreme example and i know that you will say hey there will be so many machines which are required to make 5 million t-shirts what you
Are talking is absolutely ridiculous you cannot fit so many machines in a 5000 rent factory i know but my point is that economies of scale kick in because of operating leverage every business has certain fixed cost and certain variable costs so fixed costs remaining fix irrespective to the level of output if you are able to achieve near maximum output from your
Given fixed cost your fixed cost per unit comes down drastically and once your fixed cost per unit comes down drastically either it can lead to increase in profits or you can pass on this benefit to the customer by reducing the price of its products so that is why why chinese products are cheap because they are able to achieve economies of scale by spreading their
Fixed cost over very large number of units and hence they are able to sell at much competitive prices let’s come to financial leverage what is financial leverage financial leverage is using a own money and borrowed money in a optimum way within our capital structure to achieve maximum return on investment for our investors now this is technical let me explain in
Simple language in simple language let us say if you are putting your own money in business if you had not put this money in business you would have put this money somewhere in some other business which would have hypothetically assumed made you 30% return on investment now i know 30 percent is too high but if you look at any manufacturing or trading business with
The fast turnover 30 percent is pretty much achievable and you are borrowing from a bank to invest money in the same business let’s say at 12% now what happens is that your money has opportunity cost of 30 percent and bank has interest cost of 12% let us assume this business also makes 30% ry in that case let us see if you have invested hundred rupees and bank has
Interested hundred rupees for your hundred rupees you will take back your 30 but for the bank the hundred rupees which bank has given you you will pay only 12 to the bank the over and above 18 which is thirty minus twelve is the extra profit that you earn out of nothing because the hundred rupees that bank gave you bank is very happy to receive twelve and forget
The story so when you borrow your borrowing cost is fixed and if your return on investment is higher than your borrowing cost the extra profit that you earn by borrowing is nothing but financial leverage that means you are using a low cost money to fund a high revenue business and get the spread for yourself or for your investors so this in short is the concept
Of operating and financial leverage for more concepts like these stay tuned to our channel and if you have not subscribed please subscribe today our channel finance to systemic investment plan what is an si p nsip is offered by mutual fund
Transcribed from video
Operating Leverage & Financial Leverage | Finance Tube By Finance Tube