Leverage

In finance, leverage is any technique involving borrowing funds to buy an investment, estimating
that future profits will be more than the cost of borrowing.

Types of Leverage

1. Operating Leverage: The leverage associated with investment activities is called as operating
leverage. It is caused due to fixed operating expenses in the company. Operating leverage may
be defined as the company’s ability to use fixed operating costs to magnify the effects of
changes in sales on its earnings before interest and taxes. Operating leverage consists of two
important costs viz., fixed cost and variable cost. When the company is said to have a high
degree of operating leverage if it employs a great amount of fixed cost and smaller amount of
variable cost. Thus, the degree of operating leverage depends upon the amount of various cost
structure. Operating leverage can be determined with the help of a break even analysis.

Uses of Operating Leverage

• Operating leverage is one of the techniques to measure the impact of changes in sales which
lead for change in the profits of the company.
• If any change in the sales, it will lead to corresponding changes in profit. • Operating

leverage helps to identify the position of fixed cost and variable cost • Operating
leverage measures the relationship between the sales and revenue of the company
during a particular period.
• Operating leverage helps to understand the level of fixed cost which is invested in the
operating expenses of business activities.
• Operating leverage describes the over all position of the fixed operating cost.

Operating Leverage [OL] = Contribution [c]/ EBIT ( operating profit)

Operating leverage = Contribution

Operating Profits/ EBIT

Degree of Operating leverage = Percentage change in Profits

Percentage change in Sales

2. Financial Leverage

Financial leverage results from using borrowed capital as a funding source when investing to expand
the firm's asset base and generate returns on risk capital. Leverage is an investment strategy of using
borrowed money—specifically, the use of various financial instruments or borrowed capital—to
increase the potential return of an investment. Leverage can also refer to the amount of debt a firm
uses to finance assets.

Leverage activities with financing activities is called financial leverage. Financial leverage represents
the relationship between the company’s earnings before interest and taxes (EBIT) or operating
profit and the earning available to equity shareholders.

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”. It involves the use of funds obtained at a
fixed
cost in the hope of increasing the return to the shareholders. “The use of long-term fixed interest
bearing debt and preference share capital along with share capital is called financial leverage or
trading on equity”.

Financial leverage may be favourable or unfavourable depends upon the use of fixed cost funds.
Favourable financial leverage occurs when the company earns more on the assets purchased with
the funds, then the fixed cost of their use. Hence, it is also called as positive financial leverage.

Unfavourable financial leverage occurs when the company does not earn as much as the funds
cost. Hence, it is also called as negative financial leverage.

Uses of Financial Leverage

• Financial leverage helps to examine the relationship between EBIT and EPS. • Financial
leverage measures the percentage of change in taxable income to the percentage change in
EBIT.
• Financial leverage locates the correct profitable financial decision regarding capital structure
of the company.
• Financial leverage is one of the important devices which is used to measure the fixed cost
proportion with the total capital of the company.
• If the firm acquires fixed cost funds at a higher cost, then the earnings from those assets, the
earning per share and return on equity capital will decrease.

Financial leverage = Sales – Variable cost – Fixed cost = EBIT

Sales – Variable cost- Fixed cost – interest = EBT

Degree of Financial leverage = Percentage change in EPS

Percentage change in EBIT

Financial Leverage [FL] = Operating income (EBIT) / Taxable income (EBT) or

FL = EBIT/ EBT

3. Combined Leverage

When the company uses both financial and operating leverage to magnification of any change in
sales into a larger relative change in earning per share.

Combined leverage is also called as composite leverage or total leverage.

Combined leverage expresses the relationship between the revenue in the account of sales and the
taxable income.
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CL = C/ EBT

Composite leverage = Operating leverage * Financial leverage

Degree of composite leverage = Percentage changes in EPS / Percentage changes in Sales

Numericals

Illustration 1
ABC Ltd. produced and sold 100000 units of a product at the rate of Rs. 10 per unit. For
production of 100000 units it has spent a variable cost of Rs. 600000 at the rate of Rs, 6 per
unit and a fixed cost of Rs. 250000. The firm has paid interest of Rs. 5000 at the rate of 5 %
and Rs. 10000 debt. Calculate operating leverage.

Solution :
Income Statement
Particulars Amount

Revenue Or Sales 100000 X10 100000

0

Variable Cost 100000 X6 600000

Contribution 400000

Less Fixed Cost 250000

EBIT OR Operating Profit 150000

Operating Leverage [OL] = Contribution [c]/ EBIT = 400000/ 150000 = 2.6 times

Illustration 2

A firm has sales of Rs. 10,00,000 variable cost of 700,000 & fixed cost 200,000 & debt of
500,000 at 10% rate of interest. What are the operating, financial & combine Leverage.

Solution :
Income Statement
Particulars Amount

Revenue Or Sales 100000

0
 Variable Cost 700000

Contribution 300000

Less Fixed Cost 200000

EBIT OR operating Profit 100000

Less: Interest 500000 x 0.10 50000

EBT 50000

Operating Leverage [OL] = Contribution [c]/ EBIT = 300000 / 100000 = 3

Times Financial Leverage = EBIT/ EBT = 100000/50000 = 2 times
Combine Leverage = C/ EBT = 300000 / 50000 = 6 Time.
Illustration 3

A firm has a sales of 100000 units at Rs. 10 Per Unit. Variable cost of the produced product is
60% of the total revenue, Fixed Cost is Rs. 200000. The firm has used a debt of Rs. 500000
at 20% interest. Calculate the Operating Leverage, Financial Leverage and Combine
Leverage.

Solution :

Income Statement
Particulars Amount

Revenue Or Sales 100000 x 10 100000

0

Variable Cost 1000000 x 0.60 600000

Contribution 400000

Less Fixed Cost 200000

EBIT OR operating Profit 200000

Less: Interest 500000 x 0.20 100000

EBT 100000

Operating Leverage [OL] = Contribution [c]/ EBIT = 400000 / 200000 = 2

Times Financial Leverage = EBIT/ EBT = 200000/100000 = 2 times
Combine Leverage = C/ EBT = 400000 / 100000 = 4Time.