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Assignment No 3

This document discusses leverage and its relationship to a company's income statement. It defines three types of leverage: 1) Operating leverage is related to how fixed operating costs impact earnings before interest and taxes (EBIT) as sales change. It is measured by the degree of operating leverage (DOL). 2) Financial leverage is related to how fixed financial costs, like interest and preferred dividends, impact earnings per share (EPS) as EBIT changes. It is measured by the degree of financial leverage (DFL). 3) Total leverage considers the combined effects of operating and financial leverage on the relationship between sales and EPS. Total leverage reflects how fixed costs in total impact profits.

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Abdullah ghauri
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528 views

Assignment No 3

This document discusses leverage and its relationship to a company's income statement. It defines three types of leverage: 1) Operating leverage is related to how fixed operating costs impact earnings before interest and taxes (EBIT) as sales change. It is measured by the degree of operating leverage (DOL). 2) Financial leverage is related to how fixed financial costs, like interest and preferred dividends, impact earnings per share (EPS) as EBIT changes. It is measured by the degree of financial leverage (DFL). 3) Total leverage considers the combined effects of operating and financial leverage on the relationship between sales and EPS. Total leverage reflects how fixed costs in total impact profits.

Uploaded by

Abdullah ghauri
Copyright
© © All Rights Reserved
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Download as PDF, TXT or read online on Scribd
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ASSIGNMENT

On
Financial Management
Assignment No. 3

Submitted To:
Prof. Ayub Arshad
Submitted By:
Abdullah Ghauri
Registration No.
M1F17BBAM0061

Program: BBA (HONS)

Semester: 6th

University Of Central Punjab


Q no1:What is meant by the term leverage? How are operating leverage,
Financial leverage and total leverage related to the income statement?
What is leverage ?
Leverage is the results from the use of fixed-costassets or funds to magnify returns to the firm’s
owners. Leverage is closely related to the risk of being unable to meet operating and financial
obligations when due. Generally, increases in leverage result in increased return andrisk, whereas
decreases in leverage result in decreased return and risk.

Example: Assume that Company X wants to acquire an asset that costs $100,000. The
company can either use equity or debt financing. If the company opts for the first option, it will
own 100% of the asset, and there will be no interest payments. If the asset appreciates in value
by 30%, the asset’s value will increase to $130,000 and the company will earn a profit of
$30,000. Similarly, if the asset depreciates by 30%, the asset will be valued at $70,000 and the
company will incur a loss of $30,000.

How are operating leverage, Financial leverage and total leverage related to
the income statement?
The three basic types of leverage can best be defined with reference to the firm’s income
statement, as shown in the general income statement.

 Operating leverage is concerned with the relationship between the firm’s sales revenue
and its earnings before interest and taxes, or EBIT. (EBIT is a descriptive label for
operating profits.)
 Financial leverage is concerned with the relationship between the firm’s EBIT and its
common stock earnings per share (EPS).
 Total leverage is concerned with the relationship between the firm’s sales revenue and
EPS.
These financial variables can be sales, contribution, variable or fixed costs, Earnings
Before Interest and Tax, Earning per share.

operating leverage, financial leverage, and total leverage are related to the income statement
because it shows the effect of one variable/component of income statement on another
variable/component of the income statement.
It can be understood clearly from these formulas.

operating leverage= Contribution/EBIT


financial leverage= EBIT/EBT
total leverage= Contribution/EBT

Contribution=sales- variable cost.


EBIT= earnings before interest and tax.
EBT= earnings before tax.
The above 3 are variable/component of the income statement.
This diagram shows that, operating leverage, financial leverage and the total leverage are related
to the income statement because these three leverage used in income statement. First of all,
operating leverage is start from sale then in which included fixed and variable cost and after
deducting cost from sale then we find the earning before interest and tax (EBIT). Second leverage
is financial leverage, financial leverage starts from earning before interest and tax to earning per
share (EPS). Interest, taxes and preferred stock calculation is included in financial leverage. And
the third leverage is total leverage. Total leverage is the combination of operating and financial
leverage. Total leverage is starts from sale and end in earning per share.
Q no2: What are causes of operating and financial leverages, what is
relationship among operating and financial leverage. How these are
measured?

Causes of operating and financial leverages:

Operating Leverage:
 It is mainly caused by the existence of fixed operating costs.
 The operating leverage effect is the phenomenon whereby a small change in sales triggers
a relatively large change in operating income. It is caused by the presence of fixed
operating costs. The potential benefits are that if sales are rising operating income will
rise more quickly.

Financial Leverage:
 It is caused because of the existence of fixed paid securities like debts and preferred
stocks.
 Financial leverage is caused by a higher degree of fixed-income securities such as debt
and preferred equity. The more debt financing the company uses the higher its financial
leverage. A high level of financial leverage simply means high interest payments and as
such negatively affecting the entity's bottom-line earning per share.

What is relationship among operating and financial leverage?

Operating leverage is the use of fixed operating costs by the firm to magnify the effects of
changes in sales on EBIT.The higher the fixed operating costs, the greater the operating leverage.
Financial leverage is the use of fixedfinancial costs by the firm to magnify the effects of changes
in EBIT on EPS. The higher the fixed financial costs—typically, interest on debt and preferred
stock dividends—the greater the financial leverage. The total leverage of the firm is the use of
fixed costs—both operating and financial—to magnify the effects of changes in sales on EPS.
Total leverage reflects the combined effect of operating and financial leverage.

How operating and financial leverage are measured?


Financial leverage:
The potential use of fixed financial costs to magnify the effects of changes in earnings before
interest and taxes on the firm’s earnings per share.
Measuring the Degree of Financial Leverage (DFL)
The degree of financial leverage (DFL) is the numerical measure of the firm’s financial
leverage. Computing it is much like computing the degree of operating leverage. The following
equation presents one approach for obtaining the DFL.

Whenever the percentage change in EPS resulting from a given percentage change in EBIT is
greater than the percentage change in EBIT, financial leverage exists. This means that whenever
DFL is greater than 1, there is financial leverage.

Operating leverage:
The potential use of fixed operating costs to magnify the effects of changes in sales on the firm’s
earnings before interest and taxes.

Measuring the Degree of Operating Leverage (DOL)


The degree of operating leverage (DOL) is the numerical measure of the firm’s operating
leverage. It can be derived using the following equation:

Whenever the percentage change in EBIT resulting from a given percentage changein sales is
greater than the percentage change in sales, operating leverage exists.This means that as long as
DOL is greater than 1, there is operating leverage.

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