LEVERAGE

Lever is an instrument that is used to lift heavy objects with least efforts. Dictionary defines leverage as “The
mechanical advantage or power gained by using a lever”. Lever in applied in lifting heavy instruments and objects.

According to James Van Horne “Leverage is the employment of an asset or source of finance for which firm pays
fixed cost or fixed return”. If EBIT exceeds the fixed return requirement, the leverage is called favourable, when
they do not, the result is unfavourable leverage.

There are two types of leverage:

1. Operating Leverage
2. Financial Leverage

Operating Leverage: The leverage associated with investment (asset acquisition) activities. Operating leverage
is determined by the relationship between the firm’s sales revenues and its earnings before interest and taxes
(EBIT). The EBIT also called as operating profits.

Operating leverage results from the existence of fixed operating expenses in a firm’s income stream.

The operating costs of a firm fall into three categories:

(i) fixed costs which may be defined as those which do not vary with sales volume,
(ii) variable costs which vary directly with the sales of volume
(iii) semi-variable or semi-fixed costs are those which are partly fixed or partially variable. (Fixed for
certain range and then vary)

Therefore, operational terms, can be divided into (a) fixed (b) variable.

Operating leverage may be defined as the firm’s ability to use fixed operating costs to magnify the effects of
changes in sales on its earnings before interest and taxes.

Financial Leverage: associated with financing activities. Financial leverage represents the relationship between
the firm’s earnings before interest and taxes (operating profits or EBIT) and the earnings available for ordinary
shareholders (i.e., equity shareholders).

Financial Leverage relates to the financing activities of a firm. The sources from which funds can be raised by a
firm, from the point of view of the cost/charges, can be categorized into

(i) those which carry a fixed financial charge

(ii) those which do not involve any fixed charges.

The sources of funds in the first category consist of various types of long-term debt, including bonds, debentures,
and preference shares. Long-term debts carry a fixed rate of interest which is a contractual obligation for the firm.
Although the dividend on preference shares is not a contractual obligation, it is a fixed charge and must be paid
before anything is paid to the ordinary shareholders. The equity shareholders are entitled to the remainder of the
operating profits of the firm after all the prior obligations are met.

Financial leverage, is defined as the ability of a firm to use fixed financial charges to magnify the effects of
changes in EBIT on the earnings per share (EPS).

In other words, the use of funds obtained at a fixed cost in the hope of increasing the return to the shareholders.

Favourable or positive leverage occurs when the firm earns more on the assets purchased with the funds, than the
fixed cost of their use.

Unfavourable or negative leverage occurs when the firm does not earn as much as the funds cost.

Thus, financial leverage is based on the assumption that the firm is to earn more on the assets that are acquired by
the use of funds on which a fixed rate of interest/dividend is to be paid. The difference between the earnings from
the assets and the fixed cost on the use of the funds goes to the equity holders. In a way, therefor e, use of fixed-
interest sources of funds provides increased return on equity investment without additional requirement of funds
from the shareholders. Financial leverage is also, therefore, called as 'trading on equity'. However, in periods of

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persisting adversity when earnings are not adequate, the presence of fixed charges will imply that the shareholders
will have to bear the burden. Thus, the leverage/trading on equity will operate in the opposite direction such that
the earnings per share, instead of increasing, will actually fall as a result of the use of funds carrying fixed cost.

Combined Leverage

Combined leverage is the percentage change in EPS due to the percentage change in sales. It is the product of
operating leverage and financial leverage.

Proforma of a Statement of Income

₹
Sales xxx
Less: Variable Cost xxx
Contribution (c) xxx
Less: Fixed Cost xxx
Operating Profit/EBIT xxx
Less: Interest on Debt securities like Debentures, bonds, long-term loans, debts xxx
EBT xxx
Less: Tax xxx
EAT xxx
Less: Preference Dividend xxx
Surplus Profit/Earnings available for equity shareholders xxx
[Link] equity shares xxx
EPS xxx

𝑬𝒂𝒓𝒏𝒊𝒏𝒈𝒔 𝒂𝒗𝒂𝒊𝒍𝒂𝒃𝒍𝒆 𝒇𝒐𝒓 𝒆𝒒𝒖𝒊𝒕𝒚 𝒔𝒉𝒂𝒓𝒆𝒉𝒐𝒍𝒅𝒆𝒓𝒔

𝑬𝑷𝑺 =
𝒏𝒐.𝒐𝒇 𝒆𝒒𝒖𝒊𝒕𝒚 𝒔𝒉𝒂𝒓𝒆𝒔

(𝑬𝑩𝑰𝑻 − 𝑰)(𝟏 − 𝒕) − 𝑷𝑫
𝑬𝑷𝑺 =
𝒏

where,
𝐸𝑃𝑆 = 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑃𝑒𝑟 𝑆ℎ𝑎𝑟𝑒, 𝐸𝐵𝐼𝑇 = 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝐵𝑒𝑓𝑜𝑟𝑒 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑎𝑛𝑑 𝑇𝑎𝑥,
𝐼 = 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑐ℎ𝑎𝑟𝑔𝑒𝑠 𝑝𝑒𝑟 𝑎𝑛𝑛𝑢𝑚, 𝑡 = 𝑇𝑎𝑥 𝑟𝑎𝑡𝑒 𝑎𝑝𝑝𝑙𝑖𝑐𝑎𝑏𝑙𝑒 𝑡𝑜 𝑡ℎ𝑒 𝑓𝑖𝑟𝑚
𝑃𝐷 = 𝑃𝑟𝑒𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑, 𝑖𝑓 𝑎𝑛𝑦 , 𝑛 = 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 𝑆ℎ𝑎𝑟𝑒𝑠
Formulas
Operating 𝑪𝒐𝒏𝒕𝒓𝒊𝒃𝒖𝒕𝒊𝒐𝒏
𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑳𝒆𝒗𝒆𝒓𝒂𝒈𝒆 =
Leverage 𝑬𝑩𝑰𝑻

Degree of 𝑷𝒆𝒓𝒄𝒆𝒏𝒕𝒂𝒈𝒆 𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑬𝑩𝑰𝑻

𝑫𝒆𝒈𝒓𝒆𝒆 𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑳𝒆𝒗𝒆𝒓𝒂𝒈𝒆 = >𝟏
Operating 𝑷𝒆𝒓𝒄𝒆𝒏𝒕𝒂𝒈𝒆 𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑺𝒂𝒍𝒆𝒔
Leverage
%∆ 𝒊𝒏 𝑬𝑩𝑰𝑻
𝑫𝑶𝑳 = >𝟏
%∆ 𝒊𝒏 𝑺𝒂𝒍𝒆𝒔

Alternatively,

∆ 𝑬𝑩𝑰𝑻 ÷ 𝑬𝑩𝑰𝑻
𝑫𝑶𝑳 =
∆𝑸 ÷ 𝑸

𝑬𝑩𝑰𝑻 = 𝑸(𝑺 − 𝑽) − 𝑭
∆𝑬𝑩𝑰𝑻 = ∆𝑸(𝑺 − 𝑽)

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 Q-Sales quantity in units
S-Selling price per unit
V-Variable cost per unit
F-Total fixed costs

∆𝑄(𝑆 − 𝑉) 𝑄 𝑄(𝑆 − 𝑉) 𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛

𝐷𝑂𝐿 = × = =
𝑄(𝑆 − 𝑉) − 𝐹 ∆𝑄 𝑄(𝑆 − 𝑉) − 𝐹 𝐸𝐵𝐼𝑇

Financial 𝑬𝑩𝑰𝑻
𝑭𝒊𝒏𝒂𝒏𝒄𝒊𝒂𝒍 𝑳𝒆𝒗𝒆𝒓𝒂𝒈𝒆 =
Leverage 𝑬𝑩𝑻
Financial Leverage when Preference Shares are a part

𝑬𝑩𝑰𝑻
𝑭𝒊𝒏𝒂𝒏𝒄𝒊𝒂𝒍 𝑳𝒆𝒗𝒆𝒓𝒂𝒈𝒆 =
𝑷
𝑬𝑩𝑻 − 𝟏 − 𝑻

Degree of 𝑷𝒆𝒓𝒄𝒆𝒏𝒕𝒂𝒈𝒆 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑬𝑷𝑺

𝑫𝑭𝑳 = >𝟏
Financial 𝑷𝒆𝒓𝒄𝒆𝒏𝒕𝒂𝒈𝒆 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑬𝑩𝑰𝑻
Leverage Alternatively,
∆𝑬𝑷𝑺 ÷ 𝑬𝑷𝑺
𝑫𝑭𝑳 =
∆ 𝑬𝑩𝑰𝑻 ÷ 𝑬𝑩𝑰𝑻

Combined Combined Leverage is the product of Operating Leverage and Financial

Leverage (Total Leverage
risk) Degrees of Combined Leverage =
𝑫𝑪𝑳 = 𝑫𝑶𝑳 × 𝑫𝑭𝑳

%𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑬𝑩𝑰𝑻 %𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑬𝑷𝑺 %𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑬𝑷𝑺

𝑫𝑪𝑳 = × =
%𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑺𝒂𝒍𝒆𝒔 %𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑬𝑩𝑰𝑻 %𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒔𝒂𝒍𝒆𝒔

𝑪𝒐𝒏𝒕𝒓𝒊𝒃𝒖𝒕𝒊𝒐𝒏 𝑬𝑩𝑰𝑻 𝑪𝒐𝒏𝒕𝒓𝒊𝒃𝒖𝒕𝒊𝒐𝒏 𝑪𝒐𝒏𝒕𝒓𝒊𝒃𝒖𝒕𝒊𝒐𝒏

𝑫𝑪𝑳 = × = =
𝑬𝑩𝑰𝑻 𝑬𝑩𝑰𝑻 − 𝑰 𝑬𝑩𝑰𝑻 − 𝑰 𝑬𝑩𝑻

Operating Financial Combined effect

Leverage Leverage
High High This combination is very dangerous policy, which should be
avoided
Low Low This combination is very cautious policy and not assuming risk
High Low This combination has adverse effects of operating leverage were
taken care of by having low financial leverage
Low High This combination is an ideal situation. The company can follow
aggressive debt policy.