Meaning of Leverage:

The object of application of which is made to gain higher financial benefits compared to the

fixed charges payable, as it happens in physics i.e., gaining larger benefits by using lesser

amount of force.

In short, the term ‘leverage’ is used to describe the ability of a firm to use fixed cost assets or

funds to increase the return to its equity shareholders. In other words, leverage is the

employment of fixed assets or funds for which a firm has to meet fixed costs or fixed rate of

interest obligation—irrespective of the level of activities attained, or the level of operating

profit earned.

Leverage occurs in varying degrees. The higher the degree of leverage, the higher is the risk

involved in meeting fixed payment obligations i.e., operating fixed costs and cost of debt

capital. But, at the same time, higher risk profile increases the possibility of higher rate of

return to the shareholders.

Some definitions are given to have a clear idea about leverage:

According to Ezra Solomon:

“Leverage is the ratio of net returns on shareholders equity and the net rate of return on

capitalisation”.

According to J. C. Van Home:

“Leverage is the employment of an asset or funds for which the firm pays a fixed cost of

fixed return.”

Types of Leverage:

Leverages are the three types:

(i) Operating leverage

(ii) Financial leverage and

(iii) Combined leverage

1. Operating Leverage:

Operating leverage refers to the use of fixed operating costs such as depreciation, insurance

of assets, repairs and maintenance, property taxes etc. in the operations of a firm. But it does

not include interest on debt capital. Higher the proportion of fixed operating cost as compared

to variable cost, higher is the operating leverage, and vice versa.

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

Illustration 1:

A firm sells its product for Rs. 5 per unit, has variable operating cost of Rs. 3 per unit and

fixed operating costs of Rs. 10,000 per year. Its current level of sales is 20,000 units. What

will be the impact on profit if (a) Sales increase by 25% and (b) decrease by 25%?

Solution:

Expected
Particulars Present
25% -25%

Sales in (Units) 20000 25000 15000

Sales revenues (Rs. 5 each) 100000 125000 75000

Less: Variable Cost (Rs. 3

60000 75000 45000
each)

Contribution 40000 50000 30000

Less: Fixed Cost 10000 10000 10000

EBIT or Operating Profit 30000 40000 20000

(a) A 25% increase in sales (from 20,000 units to 25,000 units) results in a 33.33%
increase in EBIT (from Rs. 30,000 to Rs. 40,000).
(b) A 25% decrease in sales (from 20,000 units to 15,000 units) results in a (33.33%)
decrease in EBIT (from Rs. 30,000 to Rs. 20,000).
Illustration 2: A firm sells its product for Rs. 100 per unit, has variable operating cost of Rs.

50 per unit and fixed operating costs of Rs. 50,000 per year. Show the various level of EBIT

that would result from of i) 1000 units ii) 2000 units and iii) 3000 units.

Solution:

Expected
Particulars Present
50% -50%
Sales in (Units) 2000 3000 1000
Sales revenues 200000 300000 100000
Less: Variable Cost 100000 150000 50000
Contribution 100000 150000 50000
Less: Fixed Cost 50000 50000 50000
EBIT or Operating
50000 100000 0
Profit

(a) A 50% increase in sales (from 2000 units to 3000 units) results in a 100 % increase in
EBIT (from Rs. 50000 to Rs. 100000).
(b) A 50% decrease in sales (from 2000 units to 1000 units) results in a 100% decrease in
EBIT (from Rs. 50000 to Rs. 0).

Degree of Operating Leverage:

The earnings before interest and taxes (i.e., EBIT) changes with increase or decrease in the

sales volume. Operating leverage is used to measure the effect of variation in sales volume on

the level of EBIT.

The formula used to compute operating leverage is:

A high degree of operating leverage is welcome when sales are rising i.e., favourable market

conditions, and it is undesirable when sales are falling. Because, higher degree of operating

leverage means a relatively high operating fixed cost for recovering which a larger volume of

sales is required.

The degree of operating leverage is also obtained by using the following formula:

Degree of operating leverage (DOL) = Percentage change in EBIT / Percentage Change in

Units Sold

The value of degree of operating leverage must be greater than 1. If the value is equal to 1

then there is no operating leverage.

2. Financial Leverage:
Financial leverage is primarily concerned with the financial activities which involve rising of
funds from the sources for which a firm has to bear fixed charges such as interest expenses,
loan fees etc. These sources include long-term debt (i.e., debentures, bonds etc.) and
preference share capital.

Long term debt capital carries a contractual fixed rate of interest and its payment is obligatory
irrespective of the fact whether the firm earns a profit or not.

As debt providers have prior claim on income and assets of a firm over equity shareholders,
their rate of interest is generally lower than the expected return in equity shareholders.
Further, interest on debt capital is a tax deductible expense.

These two facts lead to the magnification of the rate of return on equity share capital and
hence earnings per share. Thus, the effect of changes in operating profits or EBIT on the
earnings per share is shown by the financial leverage.

According to Gitman financial leverage is “the ability of a firm to use fixed financial charges

to magnify the effects of changes in EBIT on firm’s earnings per share”. In other words,

financial leverage involves the use of funds obtained at a fixed cost in the hope of increasing

the return to the equity shareholders.

Illustration 3: A Ltd. has the following capital structure:

 ₹
Equity share capital of (₹100 each) 100000
10% Preference share capital of (₹100 each) 200000
10% Debentures of (₹100 each) 200000
If EBIT is i) ₹100000 ii) ₹80000 & iii) ₹120000

Calculate financial leverage under three situations. Assume 50% tax rate.

Particulars (i) (ii) (iii)

EBIT 100000 80000 120000
Less: Int. On Debentures 20000 20000 20000
EBT 80000 60000 100000
Less: Income tax (50%) 40000 30000 50000
PAT 40000 30000 50000
Less: Pref. Dividend 20000 20000 20000
Earning for Equity Sh. 20000 10000 30000
No. of Equity shares 10000 10000 10000
EPS 2 1 3
(a) A 20% increase in EBIT (from 100000 to 120000) results in a 50 % increase in EPS
(from 2 to 3).
(b) A 20% Decrease in EBIT (from 100000 to 80000) results in a 50 % Decrease in EPS
(from 2 to 1).

Illustration 4: The financial manager of the Hypothetical Ltd. Expects that its earnings
before interest and taxes (EBIT) in the current year would amount to ₹10000. The firm
has to 5% bond aggregating ₹ 40000, while the 10% preference shares of ₹20000. What
would be the EPS? Assuming the EBIT being i) ₹6000 ii) ₹14000, how would be the
EPS effected? The firm can be assumed to be in the 35% tax bracket. The number of
outstanding ordinary shares is 1000.
Curren
Particulars Case (i) Case (ii)
t
EBIT 6000 10000 14000
Less: Int. On Bond 2000 2000 2000
EBT 4000 8000 12000
Less: Income tax (35%) 1400 2800 4200
PAT 2600 5200 7800
Less: Pref. Dividend 2000 2000 2000
Earning for Equity Sh. 600 3200 5800
No. of Equity shares 1000 1000 1000
EPS 0.6 3.2 5.8
(a) A 40% increase in EBIT (from 10000 to 14000) results in a 81.25 % increase in EPS
(from 3.2 to 5.8).
(b) A 40% Decrease in EBIT (from 10000 to 6000) results in a 81.25 % Decrease in EPS
(from 3.2 to 0.6).
Degree of Financing Leverage:
Financing leverage is a measure of changes in operating profit or EBIT on the levels of
earning per share.

It is computed as:

Financial leverage = Percentage change in EPS / Percentage change in EBIT = Increase in

EPS / EPS / Increase in EBIT/EBIT

The financial leverage at any level of EBIT is called its degree. It is computed as ratio of
EBIT to the profit before tax (EBT).

Degree of Financial leverage (DFL) = EBIT / EBT

The value of degree of financial leverage must be greater than 1. If the value of degree of
financial leverage is 1, then there will be no financial leverage. The higher the proportion of
debt capital to the total capital employed by a firm, the higher is the degree of financial
leverage and vice versa.

Again, the higher the degree of financial leverage, the greater is the financial risk associated,
and vice versa. Under favourable market conditions (when EBIT may increase) a firm having
high degree of financial leverage will be in a better position to increase the return on equity
or earning per share.

3. Combined Leverage:
Operating leverage shows the operating risk and is measured by the percentage change in
EBIT due to percentage change in sales. The financial leverage shows the financial risk and is
measured by the percentage change in EPS due to percentage change in EBIT.

Both operating and financial leverages are closely concerned with ascertaining the firm’s
ability to cover fixed costs or fixed rate of interest obligation, if we combine them, the result
is total leverage and the risk associated with combined leverage is known as total risk. It
measures the effect of a percentage change in sales on percentage change in EPS.

Degree of Combined Leverage:

The combined leverage can be measured with the help of the following formula:
Combined Leverage = Operating leverage x Financial leverage
 1. A firm has sales of ₹1000000, Variable cost of ₹700000 and fixed cost of ₹200000.
Debt of ₹500000 at 10% rate of interest and 50% tax bracket. Find out the DOL, DFL
and Combined leverage.

Particulars Amount

100000
Sales revenues
0
Less: Variable Cost 700000
Contribution 300000
Less: Fixed Cost 200000
EBIT or Operating
100000
Profit
Less: Int. On Debentures 50000
EBT 50000
Less: Tax (50%) 25000
EAT 25000

i. DOL = Contribution/ EBIT = 300000/100000 = 3

ii. DFL = EBIT/EBIT – I = 100000/50000 = 2

iii. Combined Leverage = DOL* DFL = 3*2 = 6

2. Capital structure of Sigma Limited has total capital of ₹500,000 consisting of

₹300,000 of 6% debentures and ₹200,000 of equity shares of ₹100 each. The
company currently sells 50,000 units @ ₹8 per unit. Variable cost is ₹3 per unit.
Fixed cost is ₹80,000. The company comes under 50% corporate tax brackets. In the
coming financial year the company expects an increase of 20% in the sales volume.
Compute the DOL, DFL and Combined leverage.

Existing Plan Future Plan

Particulars
50000 units 60000 units

Sales revenues (8*50000 or 60000 ) 400000 480000

Less: Variable Cost (3*50000 or 60000) 150000 180000
Contribution 250000 300000
Less: Fixed Cost 80000 80000
EBIT or Operating Profit 170000 220000
 Less: Int. On Debentures 18000 18000
EBT 152000 202000
Less: Tax (50%) 76000 101000
EAT 76000 101000
Existing Plan:

i. DOL = Contribution/ EBIT = 250000/170000 = 1.47

ii. DFL = EBIT/EBIT – I = 170000/152000 = 1.12

iii. Combined Leverage = DOL* DFL = 1.47*1.12 = 1.647

Future Plan:

i. DOL = Contribution/ EBIT = 300000/220000 = 1.36

ii. DFL = EBIT/EBIT – I = 220000/202000 = 1.089

iii. Combined Leverage = DOL* DFL = 1.36*1.089 = 1.48

3. The following information is available:

Particulars Firm P Firm Q

Sales revenues 500 1000

Less: Variable Cost 200 300
Contribution 300 700
Less: Fixed Cost 150 400
EBIT or Operating Profit 150 300
Less: Int. On Debentures 50 100
EBT 100 200
You required calculating the different types of leverages for both the firms. Also
comment on their relation risk position.

Firm P:

iv. DOL = Contribution/ EBIT = 300/150 = 2

v. DFL = EBIT/EBIT – I = 150/100 = 1.50

vi. Combined Leverage = DOL* DFL = 2*1.5 = 3

Firm Q:

iv. DOL = Contribution/ EBIT = 700/300 = 2.33

v. DFL = EBIT/EBIT – I = 300/200 = 1.5

vi. Combined Leverage = DOL* DFL = 2.33*1.5 = 3.495