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Chapter 7. Ratio Analysis > Analyzing Leverage Ratios

Analyzing Leverage Ratios

The term leverage means the purchase of assets with borrowed money. Chapter 14, “Planning Profits,” goes into this subject in detail. For now, consider this example: suppose that your company retails office supplies. When you receive an order for business cards, you pay one of your suppliers 50% of the revenue to print them for you. This is a variable cost: the more you sell, the greater your cost.

But if you purchase the necessary printing equipment, you could make the business cards yourself. So doing would turn a variable cost into a largely fixed cost: no matter how many cards you sell, the cost of printing them is fixed at however much you paid for the printing equipment (apart from consumables such as paper stock). The more cards you sell, the greater your profit margin. This effect is termed operating leverage.


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