Assignment on Leverage
Module II: Capital Structure and Leverage
Basics of Financial Management (BBA 205)
Prepared for: BBA Semester-II
Prepared by: ____________________
Institution: ____________________
1. Introduction
Leverage is an important concept in financial management that explains how a firm uses fixed costs or
fixed financial charges to magnify the effect of changes in sales or operating profit on the return to
shareholders. A business uses leverage to increase returns, but leverage also increases risk. Therefore, the
study of leverage is essential while deciding a firm's capital structure and financing pattern.
2. Meaning of Leverage
The term leverage means the use of a small base to obtain a larger result. In financial management,
leverage refers to the presence of fixed operating costs, fixed financial charges, or both. Because of these fixed
commitments, a change in sales can produce a more than proportionate change in EBIT, EPS, or shareholders’
return.
3. Types of Leverage
Type Main Idea Measures Effect On
Uses fixed operating costs such as
Operating Leverage EBIT
rent, depreciation and salaries
Uses fixed financial charges such as
Financial Leverage EPS / return to equity shareholders
interest and preference dividend
Shows the combined effect of
Combined Leverage EPS from change in sales
operating and financial leverage
4. Operating Leverage
Operating leverage refers to the use of fixed operating costs in the cost structure of the firm. When a
company has fixed costs like depreciation, rent, insurance, or salaried staff, a change in sales causes a larger
change in EBIT. Thus, operating leverage measures the sensitivity of operating profit to changes in sales.
Formula: DOL = % change in EBIT / % change in Sales or DOL = Contribution / EBIT
Implications: A high degree of operating leverage means high fixed operating cost and high business risk.
It can increase profits when sales rise, but it can also reduce profits sharply when sales fall.
Example: A factory that uses expensive machinery has high depreciation. Once the machinery is installed,
additional production may cost less per unit, so a rise in sales can lead to a strong rise in EBIT.
5. Financial Leverage
Financial leverage refers to the use of fixed financial charges in the capital structure of the firm. These
fixed charges usually include interest on debt and preference dividend. When a firm uses borrowed funds, the
return to equity shareholders can rise faster than EBIT if the firm earns more than the cost of debt.
Formula: DFL = % change in EPS / % change in EBIT or DFL = EBIT / EBT
Implications: Financial leverage increases the return on equity in favourable conditions, but it also
increases financial risk because interest and other fixed charges must be paid regardless of profit level.
Example: If a company borrows money at 10% interest and uses it in a project that earns 18%, the extra
return after paying interest benefits shareholders. However, if the project earns less than the borrowing cost,
shareholders may suffer a loss.
6. Combined Leverage
Combined leverage is the joint effect of operating leverage and financial leverage. It shows how a change
in sales affects earnings available to equity shareholders through the combined impact of fixed operating cost
and fixed financial charges.
Formula: DCL = DOL × DFL or DCL = % change in EPS / % change in Sales
Significance: Combined leverage is useful in judging the total risk of the firm. If both operating leverage
and financial leverage are high, even a small fall in sales may reduce EPS drastically.
7. Operating Leverage vs Financial Leverage
Basis Operating Leverage Financial Leverage
Meaning Use of fixed operating costs Use of fixed financial charges
Main impact Affects EBIT Affects EPS / return to equity
Risk Business risk Financial risk
Key formula DOL = %ΔEBIT / %ΔSales DFL = %ΔEPS / %ΔEBIT
8. Importance of Leverage in Financial Management
It helps managers understand the relationship between sales, operating profit, and shareholder return.
It is useful in capital structure decisions, especially while choosing between debt and equity.
It helps in measuring risk and return at the operating and financing stages.
It supports profit planning, forecasting, and investment decisions.
It enables firms to maintain a balance between higher return and acceptable risk.
9. Conclusion
Leverage is a powerful concept in financial management because it explains how fixed costs and fixed
financial charges magnify the effect of sales on earnings. Operating leverage, financial leverage, and combined
leverage help managers understand profit potential as well as risk. A firm should use leverage carefully so that
it can increase shareholders’ wealth without exposing the business to excessive risk.