4

1. Leverage Technique
The term leverage represents influence or power. Leverage is the technique
which is used to evaluate risk associated with any business organisations.
The term Leverage in general refers to a relationship between two
interrelated variables. In financial analysis it 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.
2. Types of Risk

There are two types of risk: (a) Business Risk and (b) Financial Risk:
a) Business Risk: It refers to the risk associated with firm’s operations. It is
the uncertainty about the future operating income (EBIT).
b) Financial Risk: It refers to the additional risk placed on the firm’s equity
shareholders because of use debt, preference shares or both. It is the
uncertainty about the future EPS.
3. Types of Cost and Risk

COST

FIXED COST
VARIABLE COST
• Fixed cost incurs even if there is
no activity • If there is no
activity, there
• Risk of chances of non-recovery
will be zero
of fixed cost
variable cost.
• No risk of
chances of
recovery of
variable cost.

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LEVERAGES 4.2

Fixed cost associated Fixed cost associated

with Business with finance interest
operations rent on loan preferential
salaries etc. dividends.

Operating risk or Financial risk

business risk

Combined Risk

4. Understanding of Various Leverage

Particulars ` Relationship
Sales
Less: Variable cost

5. Types of Leverages:
Leverage Technique

Operational Leverage Financial Leverage Combined Leverage

• It is the relationship • It is the relationship • It is the relationship

between “SALES and between “EBIT and between “SALES and
EBIT” EPS” EBIT”
• It indicates business • It indicates financial • It indicates combined
risk associated with risk associated with risk associated with
organisation organisation organisation.
• Higher the operating • Higher the financial • Higher the combined
leverage, higher the leverage, higher the leverage, higher the
operating risk. financial risk. combined risk.

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LEVERAGES 4.3

6. Degree of Operating Leverage or Operating Leverage: Operating leverage is

used to measure operating or business risk associated with any business
organisation, DOL indicates % change in EBIT occurs due to a given %
change in Sales.
❖ If OL is 2.5 times, 1% increase in sales would result in 2.5% increase
in EBIT.
Formulae:
Contribution
Formula 1. Operating Leverage = EBIT
% 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝐵𝐼𝑇
Formula 2. Operating Leverage =% changes in Sales
Combined Leverage
Formula 3. Operating Leverage = Financial Leverage

1
Formula 4. Operating Leverage =MOS sale proportion

Notes:
❖ OL can never be between 0 and 1.
❖ Higher the fixed cost, higher the BEP, Higher the OL and higher the
operating risk.
❖ No operating fixed cost means no operating risk.
❖ Higher the proportion of MOS, lower the OL and lower operating risk.

7. Degree of Financial Leverage or Financial Leverage: Financial leverage is

used to measure financial risk associated with any business organisations.
DFL indicates % change in EPS occurs due to a given % change in EBIT.
❖ If FL is 5 times, 1% increase in EBIT would result in 5% increase in
EPS. Formulae:
Formulae:
EBIT
Formula 1. Financial Leverage = 𝑃𝐷
𝐸𝐵𝐼𝑇−
1−𝑇

% 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝑃𝑆
Formula 2. Financial Leverage =% changes in EBIT
Combined Leverage
Formula 3. Financial Leverage =Operating Leverage
Notes:
❖ FL can never be between 0 and 1.
❖ Higher the Financial fixed cost (interest and preference dividend),
higher the Financial BEP, Higher the FL and higher the financial risk.
❖ No Financial fixed cost means no financial risk.
8. Degree of Combined Leverage or Combined Leverage: Combined leverage
is used to measure combined risk associated with any business

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LEVERAGES 4.4

organisation. DCL indicates % change in EPS occurs due to a given %

change in Sales.
❖ If CL is 2 times, 1% increase in Sales would result in 2% increase in
EPS.
Formulae:
Contribution
Formula 1. Combined Leverage = 𝑃𝐷
𝐸𝐵𝐼𝑇−
1−𝑇

% 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝑃𝑆
Formula 2. Combined Leverage = % changes in SALES

Formula 3. Combined Leverage =OL×FL

9. Operating Leverage Different Cases:

Operating Technique

Negative Infinite/undefined Positive

• Combined < • Contribution =

operating fixed operating fixed
cost cost OL = 1 OL > 1
• Company is in loss • Company is in No
• EBIT < 0 (negative profit no loss • Operating fixed • Contribution>
EBIT) situation cost = 0 operating fixed
• Sales < Operating • EBIT = 0 • There is no cost
BEP • Sales=Operating operation risk • Company has
BEP • Company is operating risk
profit • Company is in
• EBIT> 0 profit
• Sales> • EBIT> 0
operation BEP • Sales>
• Sales is in MOS operating BEP
phase • Sales is in MOS
phase

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LEVERAGES 4.5

10. Financial Leverage Difference Cased:

Financial Leverage

Negative FL Infinite/undefined Positive

• EBIT < Financial • EBIT = Financial

Fixed cost fixed cost
• EPS < 0 • EBIT = 0 FL = 1 FL > 1
• EBIT < Financial • EBIT = Financial
BEP BEP • Financial fixed • EBIT >
cost = 0 Financial fixed
• There is no cost
Financial risk • Company has
• EPS > 0 financial risk
• EBIT > • EPS > 0
Financial NEP • EBIT >
Financial BEP

11. Effect of financial Leverage of Equity Investors:

Effects of Financial Leverage

Effect of use of Debt Effect of use of preferences share
capital
Situation Effect Situation Effect
Roi>rate of interest Favorable ROI (1-t) > rate of PD Favorable
Roi > rate of interest Indifference ROI (1-t) = rate of PD Indifference
Roi > rate of interest Unfavorable ROI (1-t) > rate of PD Unfavorable
12. Financial Leverage as a ‘Double edged Sword’: When the 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.
Therefore, financial leverage is also known as “double edged sword”.
13. Trading on Equity: A firm is known to have a positive/favourable
leverage when its earnings are more than the cost of debt. If earnings
are equal to or less than cost of debt, it will be an
negative/unfavourable leverage. When the quantity of fixed cost fund
is relatively high in comparison to equity capital it is said that the firm
is ‘’trading on equity”.

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LEVERAGES 4.6

PRACTICAL PROBLEMS
Q1. From the following selected operating data, determine the degree of
operating leverage. Which company has the greater amount of business
risk? Why?
Company X Company Y
(`) (`)
Sales 50,00,000 60,00,000
Fixed costs 15,00,000 30,00,000
Variable expenses as a percentage of sales are 50% for company X and
25% for company Y.
Ans. DOL - X – 2.5, Y – 3
Q2. A capital has the following capital structures
Particulars `
Equity share capital 1,00,000
10% Preference share capital 1,00,000
8% Debentures 1,25,000
The present EBIT is ` 50,000. Calculate the financial leverage
assuming that the company is in 50% tax bracket.
Ans. FL 1.25
Q3. Betastronics Ltd. Has the following balance sheet and income
statement Balance sheet as on 31st march, 2023.
Liabilities ` Assets `
Equity Capital (`10 per 8,00,000 Net Fixed Assets 10,00,000
share)
Retained Earnings 3,50,000 Current Assets 9,00,000
10% Debentures 6,00,000
Current Liabilities 1,50,000
19,00,000 19,00,000

Income Statement for the year ending 31st March, 2023

Particulars `
Sales 3,40,000
Less: Operating Exp. (including ` 60,000 depreciation) 1,20,000
EBIT 2,20,000
Less: Interest @ 10% of 6,00,000 60,000
EBT 1,60,000
Less: Taxes 56,000
EAT 1,04,000

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LEVERAGES 4.7

a) Determine the degree of operating, financial and combined leverages

at the current sales level, if all operating expenses, other than
depreciation, are variable costs.
b) If total assets remain at the same level, but sales (i) increase by 20
percent and (ii) decrease by 20 percent, what will be the earnings
per share at the new sales level?
Ans.
a) Calculation of Degree of Operating (DOL), Financial (DFL) and
Combined leverages (DCL):
Contribution 3,00,000−60,000
Degree of Operating Leverage = = = 1.27
𝐸𝐵𝐼𝑇 2,20,000
EBIT 2,20,000
Degree of Financial Leverage =𝐸𝐵𝐼𝑇 = = 1.38
1,60,000

Degree Combined Leverage = DOL × DFL = 1.27 × 1.38 = 1.75

b) Earnings per share at the new sales level:
EPS if sales level increases by 20% = Existing EPS + increase
(% increase in sales × CL) `1.30 + 35% (20% × 1.75 times) = `1.755
EPS if sales level decreases by 20% = Existing EPS - decrease
(% decrease in sales × CL) `1.30 - 35% (20% × 1.75 times) = ` 0.845
Working Notes:
(i) Variable Costs = `60,000 (total cost − depreciation)
(ii) Variable Costs at:
• Sales level, `4,08,000 = `72,000 (increase by 20%)
• Sales level, `2,72,000 = `48,000 (decrease by 20%)
Q4. Kumar Company has sales of ` 25,00,000. Variable cost of ` 15,00,000
and fixed cost of ` 5,00,000 and debt of ` 12,50,000 at 8% rate of
interest. Calculate combined leverage.
Ans. CL 2.5
Q5. The Sale revenue of TM excellence Ltd. @ `20 per unit of output is `20
lakhs and Contribution is `10 lakhs. At the present level of output, the
DOL of the company is 2.5. The company does not have any Preference
Shares.
The number of Equity Shares are 1 lakh. Applicable corporate income
tax rate is 50% and the rate of interest on Debt Capital is 16% p.a.
What is the EPS (At sales revenue of `20 lakhs) and amount of Debt
Capital of the company if a 25% decline in Sales will wipe out EPS.
Ans.
(EBIT−1)(1−t) (4,00,000−1,50,0000)(1−0.50)
(A) Earnings Per Share = =
Equity shares 1,00,000

(B) Amount of DEBT = Interest ÷ Rate of interest

=1,50,000 ÷ 16% = `9,37,500

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LEVERAGES 4.8

Working Note:
(1) Calculation of Fixed Cost:
Contribution 10,00,000
DOL = = = 2.5 times
EBIT EBT

EBIT = 10,00,000 ÷ 2.5 = ` 4,00,000

Fixed Cost = Contribution – EBIT = 10,00,000 – 4,00,000 = `
6,00,000
(2) Calculation of Degree of Combined Leverage:
Question says that 25% change in sales will wipe out EPS, wipe out
means it will reduce EPS by 100%.
% Change in EPS 100%
DCL = = = 4 times
% changes in SALES 25%

(3) Calculation of EBT and Interest:

Contribution 10,00,000
DCL = = = 4 times
EBIT EBT

EBT = 10,00,000 ÷ 4 = `2,50,000

Interest = EBIT – EBT = 4,00,000 – 2,50,000 = `1,50,000
Q6. Calculate the operating, financial and combined leverage under
situations 1 and 2 and the financial plans for X and Y respectively from
the following information relating to the operating and capital structure
of a company, and also find out which gives the highest and the least
value? Installed capacity is 5000 units. Annual Production and sales at
60% of installed capacity.
Selling price per unit ` 25 Variable cost per unit ` 15
Fixed cost:
Situation 1 : ` 10,000
Situation 2 : ` 12,000
Financial Plan
X (`) Y (`)
Equity 25,000 50,000
Debt (10%) 50,000 25,000
75,000 75,000
Ans. Plan X Situation I - OL 1.5, FL 1.333, CL 2, Situation II - OL 1.67,
FL 1.38, CL 2.31
Plan Y Situation I - OL 1.5, FL 1.14, CL 1.71, Situation II - OL 1.67,
FL 1.16, CL 1.94.

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LEVERAGES 4.9

Q7. Calculate operating leverage and financial leverage under situations A,

B and C and financial plans 1, 2 and 3 respectively from the following
information relating to the operating and financial leverage which give
the highest value and the least value.
Installed capacity (units) 1,200
Actual production and sales (units) 800
Selling price per unit (`) 15
Variable cost per unit (`) 10
Fixed costs (`) Situation A 1,000
Situation B 2,000
Situation C 3,000
Financial Plan
Sources of Fund 1 2 3
Equity ` 5,000 ` 7,500 ` 2,500
Debt ` 5,000 ` 2,500 ` 7,500
Cost of Debts 12%
Q8. XYZ’ company has a choice of the following three financial plans. You
are required to calculate the financial leverage in each case.
Plan I Plan II Plan III
Equity capital ` 2,000 ` 1,000 ` 3,000
Debt ` 2,000 ` 3,000 ` 1,000
EBIT ` 400 ` 400 ` 400
Interest @10% per annum on debts in all cases.
Ans. FL Plan I 2 Plan II 4 Plan III 1.33
Q9. Calculate the operating leverage, financial leverage and combined
leverage from the following data under situations I and II and financial
plans A and B:
Installed capacity 4,000 units
Actual production and sales 75% of the Capacity
Selling price `30 per unit
Variable cost `15 per unit
Fixed cost:
Under situation I `15,000
Under situation II `20,000

Capital structure: Plan A Plan B

Equity `10,000 `15,000
Debt (rate of interest at 20%) `10,000 `5,000
Capital Employed `20,000 `20,000

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LEVERAGES 4.10

Ans.
Statement Showing OL, FL and CL
Particulars Situation I Situation II
Plan A Plan B Plan A Plan B
Sales (3,000 × `30) 90,000 90,000 90,000 90,000
Less: Variable cost 45,000 45,000 45,000 45,000
Contribution 45,000 45,000 45,000 45,000
Less: Fixed Cost 15,000 15,000 20,000 20,000
EBIT 30,000 30,000 25,000 25,000
Less: Interest 2,000 1,000 2,000 1,000
EBT 28,000 29,000 23,000 24,000
OL (Contribution ÷ EBIT) FL 1.5 1.5 1.8 1.8
(EBIT ÷ EBT) 1.07 1.03 1.09 1.04
CL (Contribution ÷ EBT) 1.61 1.55 1.96 1.88
Q10. The capital structure of the Progressive Corporation consists of an
ordinary share capital of `1,00,00,000 (share of `100 par value) and
`10,00,000 of 10% debentures. Sales increased by 20% from 1,00,000
units to 1,20,000 units, the selling price is `10 per unit; variable cost
amounts to `6 per unit and fixed expenses amount to `2,00,000. The
income tax rate is assumed to be 50%.
You are required to calculate the following:
(i) The percentage increase in earnings per share;
(ii) The degree of operating leverage at 1,00,000 units and 1,20,000
units.
(iii) The degree of financial leverage at 1,00,000 units and 1,20,000
units.
(iv) Comment on the behavior of operating and financial leverages in
relation to increase in production from 1,00,000 units to 1,20,000
units.
Ans.
(i) Calculation of % increase in EPS
Particulars 1,00,000 1,20,000
units units
Sales @ `10 per unit 10,00,000 12,00,000
Less: Variable cost 6,00,000 7,20,000
Contribution 4,00,000 4,80,000
Less: Fixed cost 2,00,000 2,00,000
Profit before interest and tax 2,00,000 2,80,000
Less: Interest @ 10% of `10 lacs 1,00,000 1,00,000
Profit before tax 1,00,000 1,80,000
Less: Tax @ 50% 50,000 90,000
Profit after tax 50,000 90,000
÷ No. of shares 1,00,000 1,00,000
Earnings per share `0.50 `0.90
% increase in EPS [(0.90 – 0.50) ÷ 0.50] × - +80%
100

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LEVERAGES 4.11

Contribution
(ii) Degree of Operating Leverage = EBIT
4,00,000
At 1,00,000 units= = 1 times
2,00,000
4,80,000
At 1,20,000 units = = 1.71 times
2,80,000
EBIT
(iii) Degree of Financial Leverage = EBT
2,00,000
At 1,00,000 units= = 2 times
1,00,000
2,80,000
At 1,20,000 units = = 1.56 times
1,80,000

(iv) Increase in production and sales will result in decrease in risk.

Q11. A Company had the following Balance Sheet as on March 31, 2006

Liabilities ` (in Assets ` (in

Crores) Crores)
Equity Share Capital 10 Fixed Assets (net) 25
(1 Crores Shares of `10 Current Assets 15
each)
Reserve and Surplus 2
15% Debentures 20
Current Liabilities 8
40 40

The additional information given is as under:

Fixed costs per annum (excluding interest): ` 8 Crores
Variable operating costs ratio : 65% of sales
Total Assets turnover ratio: 2.5 times
Income tax rate: 40%
Calculate (i) Earnings per share, (ii) Operating Leverage, (iii) Financial
Leverage, (iv) Combined Leverage.
Ans.
(i) Statement of EPS
Particulars ` (in
Crores)
Sales @ (2.50 times of `40 Crores) 100.00
Less: Variable cost @ 65% 65.00
Contribution 35.00
Less: Fixed cost 8.00
EBIT 27.00

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LEVERAGES 4.12

Less: Interest @ 15% of 20 Crores 3.00

EBT 24.00
Less: Tax @ 40% 9.60
EAT 14.40
÷ No. of Equity Shares ÷1
EPS `14.40
Contribution 35 crores
(ii) operating leverage: = – 1.296 times
EBIT 27 crores

It indicates fixed cost in cost structure. It indicates sensitivity of

earnings before interest and tax (EBIT) to change in sales at a
particular level.
EBIT 27 crores
(iii) Financial Leverage = = = 1.125 times
EBT 24 crores

The financial leverage is very comfortable since the debt service

obligation is small vis-a-vis EBIT.
(iv) Combined Leverage = OL × FL = 1.296 × 1.125 = 1.458 times
The combined leverage studies the choice of fixed cost in cost
structure and choice of debt in capital structure. It studies how
sensitive the change in EPS is vis-a-vis change in sales.
The leverages - operating, financial and combined are measures of
risk.
Q12. On the basis of following information calculate Operating leverage with
the help of Margin of Safety:

Particulars Product X
Number of Unit sold 1,000
Sale price per unit ` 50
Variable cost per unit ` 30
Fixed cost ` 15,000
Ans. Statement Showing Operating Leverage

Particulars Product
X
Sale 50,000
Less: Variable Cost per unit 30,000
Contribution 20,000
Less: Fixed cost 15,000
Earning before interest and tax 5,000
Break-even point (Fixed Cost ÷ Contribution per unit) or 750 units
(15,000 ÷ 20)
Margin of Safety (1,000 units – 750 units) 250 units
Margin of Safety to Sales (250 units ÷ 1,000 units) 0.25
Operating Leverage (1 ÷ MOS to sales ratio) or (1 ÷ 0.25) 4 times

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LEVERAGES 4.13

Q13. From the following information, prepare Income Statement of Company

A & B:

Particulars Company A Company B

Margin of safety 0.20 0.25
Interest `3,000 `2,000 33.33%
Profit volume ratio 25% 3
Financial Leverage 4 45%
Tax rate 45%
Ans. Income Statement
Particulars Company Company
A B
Sales 80,000 36,000
Less: Variable cost (b.f.) 60,000 24,000
Contribution 20,000 12,000
Less: Fixed cost (b.f.) 16,000 9,000
Profit before interest and tax 4,000 3,000
Less: Interest 3,000 2,000
Profit before tax 1,000 1,000
Less: Tax @ 45% 450 450
Profit after tax 550 550
Working Notes (Company A):
(a) Company A:
Financial Leverage = EBIT/(EBIT – Interest)
EBIT = EBIT/(EBIT - ` 3,000) = 4 times
EBIT = 4 EBIT - ` 12,000
EBIT = ` 4,000
Company B:

Financial Leverage = EBIT/(EBIT – Interest)

EBIT = EBIT/(EBIT - ` 2,000) = 3 times
EBIT = 3 EBIT - ` 6,000
EBIT = ` 3,000
(b) Company A:
Operating Leverage = 1/Margin of Safety = 1/0.20 = 5 times
Operating Leverage = Contribution/EBIT contribution/ ` 4,000 = 5
times
Contribution = ` 20,000

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LEVERAGES 4.14

Company B:
Operating Leverage = 1/Margin of Safety = 1/0.25 = 4 times
Operating Leverage = Contribution/EBIT Contribution/ ` 3,000
Contrition = 12,000 = 4 times
(c) Company A:
Sales = Contribution/PV Ratio = ` 20,000/ 0.25 = ` 80,000
Company B:
Sales = Contribution/PV Ratio = ` 12,000/0.33 = ` 36,000
Q14. Company P and Q are having same earnings before tax. However, the
margin of safety of Company P is 0.20 and, for Company Q, is 1.25
times than that of Company P. The interest expense of Company P is
`1,50,000 and, for Company Q, is 1/3rd less than that of Company P.
Further, the financial leverage of Company P is 4 and, for Company Q,
is 75% of Company P. Other information is given as below:
Particulars Company P Company Q
Profit volume ratio 25% 33.33%
Tax rate 45% 45%
You are required to prepare Income Statement for both the companies.
Ans. Income Statement

Particulars Company Company

P Q
Sales 40,00,000 18,00,000
Less: Variable cost 30,00,000 12,00,000
10,00,000 6,00,000
Contribution
Less: Fixed cost 8,00,000 4,50,000
Profit before interest and tax 2,00,000 1,50,000
Less: Interest 1,50,000 1,00,000
Profit before tax 50,000 50,000
Less: Tax @ 45%
22,500 22,500
Profit after tax
27,500 27,500
Working Notes:
(a) Margin of Safety:
For Company P = 0.20
For Company Q = 0.20 × 1.25 = 0.25
(b) Interest Expenses:
For Company P = ` 1,50,000
For Company Q = ` 1,50,000 – 1/3 of ` 1,50,000 = ` 1,00,000

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LEVERAGES 4.15

(c) Financial Leverage:

For Company P = 4
For Company Q = 4 × 755 = 3
(d) EBIT:
For Company A
Financial Leverage = EBIT/(EBIT – Interest)
4 = EBIT/(EBIT - ` 1,50,000)
4 EBIT - ` 6,00,000 = EBIT
3 EBIT = ` 6,00,000
EBIT = ` 2,00,000
For Company B
Financial Leverage = EBIT/(EBIT – Interest)
3 = EBIT/(EBIT - ` 1,00,000)
3 EBIT - ` 3,00,000 = EBIT
2 EBIT = ` 3,00,000
EBIT = ` 1,50,000
(e) Contribution:
For Company A
Operating Leverage = 1/Margin of Safety = 1/1.20 = 5
Operating Leverage = Contribution/EBIT
5 = Contribution / ` 2,00,000 Contribution = ` 10,00,000
For Company B
Operating Leverage = 1/Margin of Safety = 1/0.25 = 4
Operating Leverage = Contribution/EBIT
4 = Contribution/ ` 1,50,000 Contribution = ` 6,00,000
(f) Sales:
For Company A
Profit Volume Ratio = 25%
Profit Volume Ratio = (Contribution/Sales) × 100 25% = `
10,00,000/Sales
Sales = ` 10,00,000/25%
Sales = ` 40,00,000
For Company B
Profit Volume Ratio = 33.33%
Therefore, sales = ` 6,00,000/33.33% Sales = ` 18,00,000
Q15. Information of A Ltd. is given below:
• Earnings after tax: 5% of sales
• Income tax rate: 50%
• Degree of Operating leverage: 4 times
• 10% Debenture in capital structure: `3 lakhs
• Variable costs: `6 lakhs

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LEVERAGES 4.16

Required:
(i) From the given data complete following statement:
Sales XXXXX
Less: Variable Costs ` 6,00,000
Contribution XXXXX
Less: Fixed costs XXXXX
EBIT XXXXX
Less: Interest expenses XXXXX
EBT EBT
Less: Income tax XXXXX
EAT XXXXX
(ii) Calculate Financial Leverage and Combined Leverage.
(iii) Calculate percentage change in earning per share, if sales increased
by 5%.
Ans. (i) Statement of EAT

Particulars `
Sales 12,00,000
Less: Variable Costs 6,00,000
Contribution 6,00,000
Less: Fixed costs 4,50,000
EBIT 1,50,000
Less: Interest expenses @ 10% of `3 lakhs 30,000
EBT 1,20,000
Less: Income tax 60,000
EAT @5% of `12,00,000 `60,000
EBIT 1,50,000
(ii) Financial Leverage = = = 1.25 times
EBT 1,20,000

Combined leverage = OL × FL = 4× 1.25 = 5 times

(iii) % change in EPS = % change in Sales × CL = 5% × 5 = 25% Increased
Working notes:
contribution contribution
(a) operating leverage = = =4
EBIT contribution−fixed cost

Contribution = 4 Contribution = 4 Fixed Cost

Profit Volume Ratio = 25%
- 3 Contribution = - 4 Fixed cost
¾ Contribution = Fixed Cost
Contribution = Sales – Variable cost = Sales - ` 6,00,000
∴ Fixed cost = ¾ or 75% of contribution = 75% (Sales - `6,00,000)
= 75% Sales - `4,50,000

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LEVERAGES 4.17

(b) EAT = 5% of Sales

EBT = EAT ÷ (1 - t) = 5% Sales ÷ (1 – 0.5) = 10% Sales
(c) EBT = Sales – Variable cost – Fixed cost – Interest
10% Sale = Sale - ` 6,00,000 – (75% Sales - ` 4,50,000) - ` 30,000
10% Sales = Sales - ` 6,00,000 – 75% Sales + ` 4,50,000 - ` 30,000
10% Sales = 25% Sales - ` 1,80,000
15% Sales = ` 1,80,000
Sales = ` 1,80,000 ÷ 15% = ` 12,00,000
(d) EBT = 10% of Sales = 10% of `12,00,000 = `1,20,000
(e) EBIT = EBT + Interest = `1,20,000 + `30,000 = `1,50,000
(f) Fixed cost = 75% of Contribution = 75% of `6,00,000
Q16. 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).
Assuming tax rate 50%
Calculate:
(1) Operating Leverage
(2) Financial Leverage
(3) Combined Leverage
(4) Return on Investment as ROE
(5) If the sales increases by ` 6,00,000; what will the new EBIT?
Ans.
Contribution 12,00,000
(1) Operating Leverage = = = 6 times
EBIT 2,00,000
EBIT 2,00,000
(2) Financial Leverage = EBT = = 2 times
1,00,000

(3) Combined Leverage = OL × FL = 6 × 2 = 12 times

earning for equity 50,000
(4) ROI as ROE = × 100 = × 100 = 5%
equity shareholder′ sfund 10,00,000

(5) New EBIT:

Δ EBIT (in %) = Δ Sales × DOL = 25% × 6 times = 150% or 1.5
times
New EBIT = Existing EBIT + 150% = 2,00,000 + 150% = `
5,00,000

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LEVERAGES 4.18

Calculation of EPS
Particulars `
Sales 24,00,000
Less: Variable cost @ of 50% of sales 12,00,000
Contribution 12,00,000
Less: Fixed cost 10,00,000
EBIT 2,00,000
Less: Interest @ 10% of 10,00,000 1,00,000
EBT 1,00,000
Less: Tax @ 50% 50,000
EAT 50,000
Q17. A firm has sales of `75,00,000 variable cost is 56% and fixed cost is
`6,00,000. It has a debt of `45,00,000 at 9% and equity of `55,00,000.

(i) What is the firm’s ROI?

(ii) Does it have favourable financial leverage?
(iii) If the firm belongs to an industry whose capital turnover is 3, does
it have a high or low capital turnover?
(iv) What is the operating, financial and combined leverages of the
firm?
(v) If the sales are increased by 10% by what percentage EBIT will
increase?
(vi) At what level of sales, the EBT of the firm will be equal to zero?
(vii) If EBIT increases by 20%, by what percentage EBT will increase?

Ans.
Income Statement
Particulars `
Sales 75,00,000
Less: Variable cost @ of 56% of sales 42,00,000
Contribution 33,00,000
Less: Fixed costs 6,00,000
EBIT 27,00,000
Less: Interest @ 9% of 45,00,000 4,05,000
EBT 22,95,000
EBIT 27,00,000
(i) ROI = × 100 = × 100 = 27%
Capital Employed 45,00,000+55,00,000
(ii) ROI is 27% and Interest on debt is 9%, hence, it has a favourable
financial leverage.
Net Sales 75,00,000
(iii) Capital Turnover = = = 0.75
Capital 1,00,00,000
Firm has very low capital turnover as compared to industry
average of 3.
(iv) Calculation of Operating, Financial and Combined leverages:

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LEVERAGES 4.19

contribution 33,00,000
Operating Leverage = = = 1.222
EBIT 27,00,000
EBIT 27,,00,000
Financial Leverage = EBT = = 1.176
22,95,000
Combined Leverage = OL × FL = 1.222 × 1.176 = 1.437
(v) Operating leverage is 1.22. So if sales is increased by 10% then
EBIT will be increased by 1.222 × 10 i.e. 12.22% (approx)
(vi) (vi) EBT = Sales – Variable cost – Fixed cost – Interest Nil = Sales
– 56% sales – 6,00,000 – 4,05,000, 44% of sales = 10,05,000
Sales = 22,84,091. Hence at `22,84,091 sales level EBT of the
firm will be equal to Zero.
(vii) Financial leverage is 1.176. So, if EBIT increases by 20% then
EBT will increase by 1.18 × 20% = 23.52% (approx.)

Q18. The following summarizes the percentage changes in operating income,

percentage changes in revenue, and Beta factors for four
pharmaceutical firms.
Name of Change in Change in Operating Beta
Firm Revenue Income Factor
PQR Ltd 27% 25% 1.00
RST Ltd 25% 32% 1.15
TUV Ltd 23% 36% 1.30
WXY Ltd 21% 40% 1.40
Required:
(i) Calculate the degree of operating leverage for each of these firms.
Comment also.
(ii) Use the operating leverage to explain why these firms have
different beta.
Ans. (i) Calculation of operating leverage
Particulars PQR RST TUV WXY
Ltd Ltd Ltd Ltd
Degree of Operating Leverage 25% 32% 36% 40%
% Change in operating income 27% 25% 23% 21%
% change in Revenue 0.93 1.28 1.57 1.91

WXY Ltd is operating its business with higher business risk.

(ii) High operating leverage leads to high beta. So when operating
leverage is lowest i.e. 0.9259, Beta is minimum 1.00 and when
operating leverage is maximum i.e. 1.9048, beta is highest i.e. 1.40.

CA IQTIDAR MALIK FCA, CS, B com