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Inancing Ecisions Everages: Analysis of Leverage

(i) Leverage refers to the influence of one financial variable over another. There are three types of leverage: operating, financial, and combined. (ii) Operating leverage is the relationship between sales and EBIT and indicates business risk. Financial leverage is the relationship between EBIT and EPS and indicates financial risk. Combined leverage is the relationship between sales and EPS and indicates total risk. (iii) Firms with high fixed costs and high operating leverage will have higher break-even points and greater sensitivity of profits to changes in sales volume. Margin of safety is inversely related to the degree of operating leverage. Combined leverage is the product of operating leverage and financial leverage.

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91 views8 pages

Inancing Ecisions Everages: Analysis of Leverage

(i) Leverage refers to the influence of one financial variable over another. There are three types of leverage: operating, financial, and combined. (ii) Operating leverage is the relationship between sales and EBIT and indicates business risk. Financial leverage is the relationship between EBIT and EPS and indicates financial risk. Combined leverage is the relationship between sales and EPS and indicates total risk. (iii) Firms with high fixed costs and high operating leverage will have higher break-even points and greater sensitivity of profits to changes in sales volume. Margin of safety is inversely related to the degree of operating leverage. Combined leverage is the product of operating leverage and financial leverage.

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Parth Bindal
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FINANCING DECISIONS

- LEVERAGES

Analysis of Leverage

Types of Leverage
(i) Operating Leverage
Business and Financial Risk
(ii) Financial Leverages
(iii) Combined Leverages
INTRODUCTION
Objective of financial management is to maximize wealth. Here wealth means
market value. Value is directly related to performance of company and inversely
related to expectation of investors. In turn expectation of investor is dependent on
risk of the company. Therefore, to maximize value company should try to manage
its risk. This risk may be business risk, financial risk or both. In this chapter we will
discuss factors that influence business and financial risks.

MEANING AND TYPES OF LEVERAGE


Meaning of Leverage
The term leverage represents influence or power. In financial analysis leverage
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.

Types of Leverage
There are three commonly used measures of leverage in financial analysis. These are:

(i) Operating Leverage: It is the relationship between Sales and EBIT and indicated
business risk.

(ii) Financial Leverage: it is the relationship between EBIT and EPS and indicates
financial risk.

(iii) Combined Leverage: It is the relationship between Sales and EPS and indicated
total risk.
Chart Showing Operating Leverage, Financial Leverage and Combined
leverage
Profitability Statement
Sales xxx
Less: Variable Cost (xxx)
Contribution xxx Operating Leverage
Less: Fixed Cost (xxx)
Operating Profit/ EBIT xxx
Less: Interest (xxx)
Earnings Before Tax (EBT) xxx Degree of
Combined
Leverage
Less: Tax (xxx)
Profit After Tax (PAT) xxx Financial Leverage
Less: Pref. Dividend (if any) (xxx)
Net Earnings available to equity xxx
shareholders/ PAT
No. Equity shares (N)
Earnings per Share (EPS) = (PAT
÷ N)

OPERATING LEVERAGE
Operating Leverage means tendency of operating income (EBIT) to change
disproportionately with change in sale volume. This disproportionate change is
caused by operating fixed cost, which does not change with change in sales volume.
In other words, operating leverage (OL) maybe defined as the employment of an
asset with a fixed cost so that enough revenue can be generated to cover all the
fixed and variable costs.
The use of assets for which a company pays a fixed cost is called operating leverage.
Operating leverage is a function of three factors:
(i) Amount of fixed cost,
(ii) Variable contribution margin, and
(iii) Volume of sales.
Degree of Operating Leverage (DOL)

Percentage Change in EBIT


Degree of Operating Leverage=
Percentage Change in Sales
Break-Even Analysis and Operating Leverage
Break-even analysis is a generally used to study the Cost Volume Profit analysis. It
is concerned with computing the break-even point. At this point of production level
and sales there will be no profit and loss i.e. total cost is equal to total sales revenue.
Fixed Cost
Break-even point in units =
Contribution per unit
Let us Understand through the following example:

Particulars Product X Product Y


(`) (`)
Selling Price 40 20
Variable Cost 20 12
Contribution 20 8
Total Contribution of 1,000 units 20,000 8,000
Fixed Cost 15,000 5,000
Profit (EBIT) 5,000 3,000
Break- even point (Fixed Cost / 15,000 5,000
= 750 units = 625 units
Contribution 20 8
 Contribution  20,000 8,000
Operating Leverage   =4 = 2.67
EBIT 5,000 3,000
 
There is a relationship between leverage and Break-even point. Both are used for
profit planning. In brief the relationship between leverage,break-even point and fixed
cost as under:

Leverage Break-even point


1. Firm with high leverage 1. Higher Break-even point
2. Firm with low leverage 2 .Lower Break-even point
Fixed cost Operating leverage
1. High fixed cost 1. High degree of operating leverage
2. Lower fixed cost 2. Lower degree of operating leverage
Margin of Safety and Operating Leverage
In cost accounting, one studies that margin of safety (MOS) may be calculated as
follows:

So
Contribution-Fixed Cost EBIT
MOS= =
Contribution Contribution

we know that:
Contribution
DOL=
EBIT
hence:
1
Degree of Operating leverage=
Margin of Safety
FINANCIAL LEVERAGE
Financial leverage (FL) maybe defined as ‘the use of funds with a fixed cost in
order to increase earnings per share.’ In other words, it is the use of company
funds on which it pays a limited return. Financial leverage involves the use of funds
obtained at a fixed cost in the hope of increasing the return to common
stockholders.
Earnings before interest and tax(EBIT)
Financial Leverage (FL) =
Earnings before tax(EBT)

Where, EBIT = Sales - (Variable cost+ Fixed cost)


EBT = EBIT - Interest

COMBINED LEVERAGE
Combined leverage maybe defined as the potential use of fixed costs, both
operating and financial, which magnifies the effect of sales volume change on
the earning per share of the firm.

Combined Leverage (CL) = Operating Leverage (OL) × Financial Leverage (FL)


C EBIT
= ×
EBIT EBT
C
=
EBT

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