LEVERAGES
Analysis of Leverage
Types of Leverage
(i) Operating Leverage
Business and Financial Risk
(ii) Financial Leverages
(iii) Combined Leverages
FINANCIAL MANAGEMENT
INTRODUCTION
Objective of financial management is to maximize wealth. Here wealth means
market value. Value is directly related to performance of company and inversely
related to expectation of investors. In turn expectation of investor is dependent on
risk of the company. Therefore, to maximize value company should try to manage
its risk. This risk may be business risk, financial risk or both.
MEANING AND TYPES OF LEVERAGE
Meaning of Leverage
The term leverage represents influence or power. In financial analysis leverage
represents the influence of one financial variable over some other related financial
variable. These financial variables may be costs, output, sales revenue, Earnings
before Interest and Tax (EBIT), Earning per share (EPS) etc.
Types of Leverage
There are three commonly used measures of leverage in financial analysis. These are:
(i) Operating Leverage: It is the relationship between Sales and EBIT and indicated
business risk.
(ii) Financial Leverage: it is the relationship between EBIT and EPS and indicates
financial risk.
(iii) Combined Leverage: It is the relationship between Sales and EPS and indicated
total risk.
FINANCING DECISIONS - LEVERAGES
Chart Showing Operating Leverage, Financial Leverage and Combined
leverage
Profitability Statement
Sales xxx
Less: Variable Cost (xxx)
Contribution xxx Operating Leverage
Less: Fixed Cost (xxx)
Operating Profit/ EBIT xxx
Less: Interest (xxx)
Earnings Before Tax (EBT) xxx Degree of
Combined
Leverage
Less: Tax (xxx)
Profit After Tax (PAT) xxx Financial Leverage
Less: Pref. Dividend (if any) (xxx)
Net Earnings available to xxx
equity shareholders/ PAT
No. Equity shares (N)
Earnings per Share (EPS) =
(PAT
÷ N)
OPERATING LEVERAGE
Operating Leverage means tendency of operating income (EBIT) to change
disproportionately with change in sale volume. This disproportionate change is
caused by operating fixed cost, which does not change with change in sales volume.
In other words, operating leverage (OL) maybe defined as the employment of an
asset with a fixed cost so that enough revenue can be generated to cover all the
fixed and variable costs.
The use of assets for which a company pays a fixed cost is called operating leverage.
Operating Leverage= Contribution / EBIT
Degree of Operating Leverage (DOL)
Degree of Operating Leverage may be defined as percentage change in EBIT with
respect to percentage change in sales quantity.
Percentage Change in EBIT
Degree of Operating Leverage=
Percentage Change in Sales
ILLUSTRATION 1
A Company produces and sells 10,000 shirts. The selling price per shirt is ` 500.
Variable cost is ` 200 per shirt and fixed operating cost is ` 25,00,000.
(a) CALCULATE operating leverage.
(b) If sales are up by 10%, then COMPUTE the impact on EBIT?
SOLUTION
(a) Statement of Profitability
`
Sales Revenue (10,000 × 500) 50,00,000
Less: Variable Cost (10,000 × 200) 20,00,000
Contribution 30,00,000
Less: Fixed Cost 25,00,000
EBIT 5,00,000
FINANCIAL MANAGEMENT
Operating Leverage Contribution 30 lakhs
= = = 6 times
EBIT 5 lakhs
% Changein EBIT
(b) Operating Leverage (OL) =
% ChangeinSales
X / 5,00,000
6 = 5,00,000 50,00,000
X = `3,00,000
EBIT = `3,00,000/5,00,000= 60%
ILLUSTRATION 2
CALCULATE the operating leverage for each of the four firms A, B, C and D from the
following price and cost data:
Firms
A B(`) C(`) D(`)
Sale price per unit 20 32 50 70
Variable cost per unit 6 16 20 50
Fixed operating cost 60,000 40,000 1,00,000 Nil
What calculations can you draw with respect to levels of fixed cost and the degree of
operating leverage result? Explain. Assume number of units sold is 5,000.
SOLUTION
Firms
A B C D
Sales (units) 5,000 5,000 5,000 5,000
Sales revenue (Units × price) 1,00,000 1,60,000 2,50,000 3,50,000
Less: Variable cost (30,000) (80,000) (1,00,000) (2,50,000)
(Units × variable cost per unit)
Less: Fixed operating costs (60,000) (40,000) (1,00,000) Nil
EBIT 10,000 40,000 50,000 1,00,000
FINANCING DECISIONS - LEVERAGES
Current sales (S) - Variable costs (VC)
DOL = Current EBIT
DOL 1,00,000 ` 30,000
7
( A)
`10,000
DOL(B) 1,60,000 ` 80,000
2
40,000
DOL
2,50,000 ` 1,00,000
(C) 3
50,000
DOL(D) 3,50,000 ` 2,50,000 1
1,00,000
The operating leverage exists only when there are fixed costs. In the case of firm D,
there is no magnified effect on the EBIT due to change in sales. A 20 per cent
increase in sales has resulted in a 20 per cent increase in EBIT. In the case of other
firms, operating leverage exists. It is maximum in firm A, followed by firm C and
minimum in firm B. The interception of DOL of 7 is that1 per cent change in sales
results in 7 per cent change in EBIT level in the direction of the change of sales level
of firm A.
FINANCIAL LEVERAGE
Financial leverage (FL) maybe defined as ‘the use of funds with a fixed cost in
order to increase earnings per share.’ In other words, it is the use of company
funds on which it pays a limited return. Financial leverage involves the use of funds
obtained at a fixed cost in the hope of increasing the return to common stockholders.
Earnings before interest and tax(EBIT)
Financial Leverage (FL) =
Earnings before tax(EBT)
Where, EBIT = Sales - (Variable cost+ Fixed cost)
EBT = EBIT - Interest
Degree of Financial Leverage (DFL)
Degree of financial leverage is the ratio of the percentage increase in earnings per
share (EPS) to the percentage increase in earnings before interest and taxes (EBIT).
Financial Leverage (FL) is also defined as “the ability of a firm to use fixed financial
charges to magnify the effect of changes in EBIT on EPS
FINANCIAL MANAGEMENT
Degree of Financial Leverage (DFL)
Percentage change in earnings per share (EPS)
=
Percentage change in earnigs before interest and tax (EBIT)
When DFL is more than one (1), financial leverage exists. More is DFL higher is
financial leverage.
A positive DFL/ FL means firm is operating at a level higher than break-even point
and EBIT and EPS moves in the same direction. Negative DFL/ FL indicates the firm is
operating at lower than break-even point and EPS is negative.
Let us understand through the following analysis:
Situation 1:No Fixed Interest Charges
Particulars X Y
` `
EBIT 1,00,000 1,50,000
Tax @ 50% 50,000 75,000
FINANCING DECISIONS - LEVERAGES
PAT 50,000 75,000
No. of share 10,000 10,000
EPS 5 7.5
Change in EP
Degree of Finance Leverage - (DFL) = 50%
Change in EBIT = 50% =1
Situation 2. Positive Financial Leverage
Particular M N
EBIT 1,00,000 1,50,000
Interest 20,000 20,000
EBT 80,000 1,30,000
Tax @ 50% 40,000 65,000
PAT 40,000 65,000
No of Share 10,000 10,000
4 6.5
Degree of Finance Leverage - (DFL)=
Change in EPS 62.5%*
* Change in EBIT = 50% =1.25
2.5
×100
4
= 62.5%
50%
Situation 3. When EBT is nil (EBIT = Fixed Interest)
EBIT
Degree of Finance Leverage = = undefined.
Nil
Analysis and Interpretation of Financial
leverage
Sl. Situation Result
No.
1 No Fixed Financial Cost No Financial leverage
2. Higher Fixed Financial cost Higher Financial Leverage
3. When EBIT is higher than Financial Break-even Positive Financial leverage
point
4. When EBIT is levy then Finance Break-even point Negating Financial leverage
Financial Leverage as ‘Trading on Equity’
Financial leverage indicates the use of funds with fixed cost like long term debts
and preference share capital alongwith equity share capital which is known as
trading on equity. The basic aim of financial leverage is to increase the earnings
available to equity shareholders using fixed cost fund. A firm is known to have a
positive leverage when its earnings are more than the cost of debt. If earnings is
equal to or less than cost of debt, it will be an unfavourable leverage. When the
FINANCING DECISIONS - LEVERAGES
quantity of fixed cost fund is relatively high in comparison to equity capital it is said
that the firm is ‘’trading on equity”.
Financial Leverage as a ‘Double edged Sword’
On one hand when cost of ‘fixed cost fund’ is less than the return on investment
financial leverage will help to increase return on equity and EPS. The firm will also
benefit from the saving of tax on interest on debts etc. However, when cost of debt
will be more than the return it will affect return of equity and EPS unfavourably and
as a result firm can be under financial distress. This is why financial leverage is known
as “double edged sword”.
COMBINED LEVERAGE
Combined leverage maybe defined as the potential use of fixed costs, both
operating and financial, which magnifies the effect of sales volume change on
the earning per share of the firm.
Combined Leverage (CL) = Operating Leverage (OL) × Financial Leverage (FL)
C EBIT
= ×
EBIT EBT
C
=
EBT
ee of Combined Leverage (DCL)
Degree of combined leverage (DCL) is the ratio of percentage change in earning per
share to the percentage change in sales. It indicates the effect the sales changes
will have on EPS.
DCL = DOL × DFL
% Changein EBIT % Change in EPS
= ×
% Changein Sales % Change in EBIT
% Changein EPS
=
% Changein Sales
Like operating leverage and financial leverage, combined leverage can also be
positive and negative combined leverage.
Analysis of combined leverage
Combine leverage measures total risk. It depends on combination of operating and
financial risk.
DOL DFL Comments
Low Low Lower total risk. Can not take advantage of trading on equity.
High High Higher total risk. Very risky combination.
FINANCING DECISIONS - LEVERAGES
High Low Moderate total risk. Not a good combination. Lower EBIT due to
higher DOL and lower advantage of trading on equity due to low
DFL.
Low High Moderate total risk. Best combination. Higher financial risk is
balanced by lower total business risk.
ILLUSTRATION 3
A firm’s details are as under:
Sales (@100 per unit) ` 24,00,000
Variable Cost 50%
Fixed Cost ` 10,00,000
It has borrowed ` 10,00,000 @ 10% p.a. and its equity share capital is ` 10,00,000 (`
100 each)
CALCULATE:
(a) Operating Leverage
(b) Financial Leverage
(c) Combined Leverage
(d) Return on Investment
(e) If the sales increases by ` 6,00,000; what will the new EBIT?
SOLUTION
`
Sales 24,00,000
Less: Variable cost 12,00,000
Contribution 12,00,000
Less: Fixed cost 10,00,000
EBIT 2,00,000
Less: Interest 1,00,000
EBT 1,00,000
Less: Tax (50%) 50,000
FINANCIAL MANAGEMENT
EAT 50,000
No. of equity shares 10,000
EPS 5
12,00,000
(a) Operating Leverage 6 times
2,00,000
2,00,000
(b) Financial Leverage 2 times
1,00,000
(c) Combined Leverage = OL × FL = 6 × 2 = 12 times.
50,000
(d) R.O. I 100 5%
10,00,000
[Link]
Here ROI is calculated as ROE i.e.
Equity shareholders ‘fund
(e) Operating Leverage = 6
Δ EBIT
6 = 0.25
6 1
Δ EBIT 1.5
4
Increase in EBIT = ` 2,00,000 × 1.5 = ` 3,00,000
New EBIT = 5,00,000
DOL DFL DCL
Shows level of business Shows level of financial Shows level of total or
risk. risk. combined risk.
It is dependent upon It is dependent upon It is dependent upon fixed
fixed cost. interest and preference cost, interest & preference
dividend dividend.
Measures % change in Measures % change in EPS Measures % change in EPS
EBIT which results from a which results from a 1% which results from a 1%
1% change in Sales. change in EBIT. change in Sales.
FINANCING DECISIONS - LEVERAGES
For example, if DOL is 3 For example, if DFL is 2 For example, if DCL is 6
& there is 8% increase in and there is 5% increase in and there is a 8% increase
output then EBIT will EBIT then EPS will increase in sales then EPS will
increase by 24% & if by 10% and if there is a increase by 48%. And if
there is a 8% decrease in 5% decrease in EBIT, EPS there is a 8% decrease in
output EBIT will decrease will decrease by 10%. sales then EPS will
by 24%. decrease by 48%.
There is unique DOL for There is a unique DFL for There is a unique DCL for
each level of output. each level of EBIT. each level of sales.
It is undefined at It is undefined at Financial It is undefined at Financial
Operating B.E.P. B.E.P. B.E.P.