Financial Management Unit 6

Unit 6 Leverage
Structure:
6.1 Introduction
Objectives
6.2 Operating Leverage
Application of operating leverage
6.3 Financial Leverage
Use of financial leverage
6.4 Total or Combined Leverage
Uses of Degree of Total Leverage (DTL)
6.5 Summary
6.6 Glossary
6.7 Solved Problems
6.8 Terminal Questions
6.9 Answers
6.10 Case Study

6.1 Introduction
In the previous unit, you have learnt about the meaning of cost of capital,
cost of different sources of finance, and Weighted Average Cost of Capital
(WACC). In this unit, we will discuss the concepts of operating leverage,
financial leverage, and total or combined leverage.
A company uses different sources of financing to fund its activities. These
sources can be classified as those which carry a fixed rate of return and
those whose returns vary. These were discussed in the earlier units. The
fixed sources of finance have a bearing on the return on shareholders.
Borrowing funds as loans have an impact on the return on shareholders,
and this is greatly affected by the magnitude of borrowing in the capital
structure of a firm.
‘Leverage’ means ‘effectiveness’ or ‘power’. The use of an asset or source
of funds for which the company has to pay a fixed cost or fixed return is
termed as leverage. Leverage studies how the dependent variable responds
to a particular change in the independent variable.

Manipal University Jaipur B1628 Page No. 147

Financial Management Unit 6

Figure 6.1 depicts the three types of leverages – operating, financial, and
combined.

Figure 6.1: Types of Leverage

Operating leverage is associated with the asset purchase activities, while

financial leverage is associated with the financial activities. However,
combined leverage is the combination of operating leverage and the
financial leverage.
Thus, the term leverage refers to an increased means of accomplishing
some purpose. With leverage, it is possible to lift objects which are
otherwise impossible. The term refers, generally, to circumstances which
bring about an increase in income volatility. In business, leverage is the
means of increasing profits. It may be favourable or unfavourable. The
former reduces profit, while the latter increases it. The leverage of a firm is
essentially related to a measure which may be a return on investment or on
earnings before taxes. It is an important tool of financial planning because it
is related to profits.
Objectives:
After studying this unit, you should be able to:
 explain operating leverage
 explain the Financial leverage
 explain the Combined Leverage

6.2 Operating Leverage

Operating leverage arises due to the presence of fixed operating expenses
in the firm’s income flows. It has a close relationship to business risk.
Operating leverage affects business risk factors, which can be viewed as
the uncertainty inherent in estimates of future operating income.

Manipal University Jaipur B1628 Page No. 148

Financial Management Unit 6

The operating leverage takes place when a change in revenue produces a

greater change in Earnings Before Interest and Taxes (EBIT). It indicates
the impact of changes in sales on operating income. A firm with a high
operating leverage has a relatively greater effect on EBIT for small changes
in sales. A small rise in sales may enhance profits considerably, while a
small decline in sales may reduce and even wipe out the EBIT.
Figure 6.2 depicts the three categories of a company’s operating costs.

Figure 6.2: Classification of Operating Costs

Let us now discuss these three categories in detail.

 Fixed costs – Fixed costs are those which do not vary with an increase
in production or sales activities for a particular period of time. These are
incurred irrespective of the income and value of sales and generally
cannot be reduced.
For example, consider that a firm named XYZ Enterprises is planning to
start a new business. The main aspects that the firm should concentrate
on are salaries to the employees, rents, insurance of the firm, and the
accountancy costs. All these aspects are referred to as “fixed costs”.
 Variable costs – Variable costs are those which vary in direct proportion
to output and sales. An increase or decrease in production or sales
activities will have a direct effect on such types of costs incurred.
For example, we have discussed about fixed costs in the above context.
Now, the firm has to concentrate on some other features like cost of
labour, amount of raw materials, and the administrative expenses. All
these features relate to or are referred to as “Variable costs”, as these
costs are not fixed and keep changing depending upon the conditions.
 Semi-variable costs – Semi-variable costs are those which are partly
fixed and partly variable in nature. These costs are typically of fixed

Manipal University Jaipur B1628 Page No. 149

Financial Management Unit 6

nature up to a certain level beyond which they vary with the firm’s
activities.
For example, after considering both the fixed costs and the variable
costs, the firm should concentrate on some other features like production
cost and the wages paid to the workers. At some point in time, these will
act as fixed costs and can also shift to variable costs. These features
relate to or are referred to as “Semi-variable costs”.
The operating leverage refers to the degree to which a firm has built-in
fixed costs due to its particular or unique production process.
The extent of the operating leverage at any single sales volume is
calculated as follows:
 Marginal contribution/EBIT)
 (Revenue – Variable costs)/(Revenue – Variable costs – Fixed costs)
In most cases, a firm would be in a position to exercise a degree of control
on the choice of its technology and the related production processes. The
production processes which are accompanied by high fixed costs but low
variable costs are generally the highly mechanised and automated
processes. With such processes, the degree of operating leverage is
generally high, the break-even point is relatively higher, and thus changes in
the sales level have a magnified (or “leveraged” ) effect on profits. Break-
even sales volume goes up with operating leverage (i.e., fixed costs), thus,
greater the impact on profits for a given change in sales volume.
Thus, the operating leverage is the firm’s ability to use fixed operating costs
to increase the effects of changes in sales on its EBIT. Operating leverage
occurs any time if a firm has fixed costs. The percentage of change in profits
with a change in volume of sales is more than the percentage of change in
volume. The higher the fixed costs, the greater the leverage and the more
frequent the changes in the rate of profit (or loss) with alternations in the
volume of activity.

Manipal University Jaipur B1628 Page No. 150

Financial Management Unit 6

Solved Problem – 1
A firm sells a product for Rs. 10 per unit. Its variable costs are Rs. 5 per
unit and fixed expenses amount to Rs. 5000 p.a. Show the various levels
of EBIT that result from sale of 1000 units, 2000 units, and 3000 units.
Solution:
Table 6.1 depicts the various levels of EBIT that result from the sale of
1000 units, 2000 units, and 3000 units.
Table 6.1: Various Levels of EBIT
Sales in units 1000 2000 3000
Sales revenue Rs. 10000 20000 30000
Variable cost 5000 10000 15000
Contribution 5000 10000 15000
Fixed cost 5000 5000 5000
EBIT 000 5000 10000

If we take 2000 units as the normal course of sales, the results can be
summed as:
 A 50% increase in sales from 2000 units to 3000 units results in a
100% increase in EBIT.
 A 50% decrease in sales from 2000 units to 1000 units results in a
100% decrease in EBIT.

The illustration clearly tells us that when a firm has fixed operating
expenses, an increase in sales results in a more proportionate increase in
EBIT and vice versa. The former is a favourable operating leverage and the
latter is unfavourable.
Another way of explaining this phenomenon is examining the effect of the
Degree of Operating Leverage (DOL). The DOL is a more precise
measurement.
DOL measures the effect of change in volume on net operating income or
earnings before interest and taxes. It examines the effect of the change in
the quantity produced on EBIT.

Manipal University Jaipur B1628 Page No. 151

Financial Management Unit 6

DOL = % change in EBIT / % change in output

To put in a different way,
(ΔEBIT/EBIT) / (ΔQ/Q)
EBIT is Q(S—V)—F
Where Q is quantity
S is sales
V is variable cost
F is fixed cost
Substituting this we get,
{Q(S—V)} / {Q(S—V)—F}
DOL will be calculated for a firm when it moves over from one level of sales
(volume or value) to another.

Solved Problem – 2
Calculate the DOL of Guptha Enterprises. Table 6.2 depicts the
information of Guptha Enterprises.
Table 6.2: Information of Guptha Enterprises

Quality produced and sold 1000 units

Variable cost Rs. 200 per unit
Selling price per unit Rs. 300 per unit
Fixed expenses Rs. 20, 000
Solution:
DOL = {Q(S–V)} / {Q(S–V)–F}
= {1000(300–200)}/{1000(300–200)–20000}
= 100000/80000
DOL = 1.25
The DOL of Guptha enterprises is 1.25.
If the company does not incur any fixed operating costs, there is no
operating leverage.

Manipal University Jaipur B1628 Page No. 152

Financial Management Unit 6

Solved Problem – 3
Calculate the DOL of Utopia Enterprises. Table 6.3 depicts the
information of Utopia Enterprises.
Table 6.3: Information of Utopia Enterprises

Quality produced and sold 2000 units

Variable cost Rs.300 per unit
Selling price per unit Rs. 400 per unit
Fixed expenses Rs.25, 000
Solution:
DOL = {Q(S–V)} / {Q(S–V)–F}
= {2000(400–300)}/{2000(400–300)–25000}
= 200000/175000
DOL = 1.14
The DOL of Utopia Enterprises is 1.14.

Solved Problem – 4
Table 6.4 depicts the statistics of a firm and its sales requirements.
Compute the DOL according to the values given in the table.
Table 6.4: Statistics of a Firm

Sales in units 1000

Sales revenue Rs. 10000

Variable cost 5000

Contribution 5000

Fixed cost 0

EBIT 5000
Solution:
DOL= {Q(S—V)} / {Q(S—V)—F}
{1000(5000)} / {1000(5000) – 0}
= 5000000/5000000
= DOL=1
The DOL according to the values given in the table is 1.

Manipal University Jaipur B1628 Page No. 153

Financial Management Unit 6

Solved Problem – 5
Table 6.5 depicts the statistics of a firm and its sales requirements.
Compute the DOL according to the values given in the table.
Table 6.5: Statistics of a Firm
Sales in units 2000
Sales revenue Rs. 20000
Variable cost 10000
Contribution 6000
Fixed cost 0
EBIT 6000
Solution:
DOL= {Q(S—V)} / {Q(S—V)—F}
{2000(10000)} / {2000(10000) – 0}
= 2000000/2000000
= DOL=1
The DOL according to the values given in the table is 1.
As operating leverage can be favourable or unfavourable, high risks are
attached to higher degrees of leverage. As DOL considers fixed expenses, a
larger amount of these expenses increases the operating risks of the
company and hence, a higher DOL. Higher operating risks can be taken
when income levels of companies are rising and should not be ventured into
when revenues move southwards.
Thus, the higher the DOL, the greater will be the fluctuations in profits in
response to changes in volume. And this relationship works both ways, i.e.,
when volume increases as well as when it declines.
6.2.1 Application of operating leverage
The applications of operating leverage are as follows:
 Business risk measurement
 Production planning
 Measurement of business risk
Risk refers to the uncertain conditions in which a company performs. A
business risk is measured using the DOL and the formula of DOL is:
DOL = {Q(S–V)} / {Q(S–V)–F}

Manipal University Jaipur B1628 Page No. 154

Financial Management Unit 6

The greater the DOL, the more sensitive will be the EBIT to a given change
in unit sales. A high DOL is a measure of high business risk and vice versa.
 Production planning
A change in production method increases or decreases DOL. A firm can
change its cost structure by mechanising its operations, thereby, reducing
its variable costs and increasing its fixed costs. This will have a positive
impact on DOL. This situation can be justified only if the company is
confident of achieving a higher amount of sales thereby increasing its
earnings.

6.3 Financial Leverage

Financial leverage relates to the financing activities of a firm and measures
the effect of EBIT on Earnings Per Share (EPS) of the company.
A company’s sources of funds fall under two categories:
 Those which carry fixed financial charges like debentures, bonds, and
preference shares
 Those which do not carry any fixed charges like equity shares
Debentures and bonds carry a fixed rate of interest and are to be paid off
irrespective of the firm’s revenues. The dividends are not contractual
obligations, but the dividend on preference shares is a fixed charge and
should be paid off before equity shareholders. The equity holders are
entitled to only the residual income of the firm after all prior obligations are
met.
Financial leverage refers to a firm's use of fixed-charge securities like
debentures and preference shares (though the latter is not always included
in debt) in its plan of financing the assets.
The concept of financial leverage is a significant one because it has direct
relation with capital structure management. It determines the relationship
that could exist between the debt and equity securities. A firm which does
not issue fixed-charge securities has an equity capital structure and does
not have any financial leverage. However, it is common for firms to issue
some debt securities, in which case, the leverage is either favourable or
unfavourable. Financial leverage is a process of using debt capital to
increase the rate of return on equity. For this reason, it is also referred to as
Manipal University Jaipur B1628 Page No. 155
Financial Management Unit 6

trading on equity. Borrowing is done by a company because of the financial

advantage that is expected from it. The use of borrowings for the purpose of
such advantage for residual shareholders is also called ‘trading on equity’ or
‘leverage’.
Thus, financial leverage refers to the mix of debt and equity in the capital
structure of the firm. This results from the presence of fixed financial
charges in the company’s income stream. Such expenses have nothing to
do with the firm’s performance and earnings and should be paid off
regardless of the amount of EBIT.
It is the firm’s ability to use fixed financial charges to increase the effects of
changes in EBIT on the EPS. It is the use of funds obtained at fixed costs
which increase the returns on shareholders.
A company earning more by the use of assets funded by fixed sources is
said to be having a favourable or positive leverage. Unfavourable leverage
occurs when the firm is not earning sufficiently to cover the cost of funds.
Financial leverage is also referred to as “trading on equity”.
Thus, the effect of financial leverage is also measured through another
variable, viz, EPS. This is done in the case of joint stock companies which
have raised their proprietary capital by selling units of such capital known as
equity shares.
EPS is obtained by dividing earnings (after interest and taxes) by total
equity. If a company has preference shares also on its capital structure, net
equity earnings will be arrived at after deducting interest, taxes, and
preference dividends.
Capital structure refers to the permanent long-term financing of a company
represented by a mix of long-term debt, preference shares, and net worth
(which included paid-up capital, reserves, and surplus).
Financial leverage and its effects are a crucial consideration in planning and
designing capital structures.

Manipal University Jaipur B1628 Page No. 156

Financial Management Unit 6

Solved Problem – 6
The EBIT of a firm is expected to be Rs. 10000. The firm has to pay
interest at a rate of 5% on debentures of worth Rs. 25000. It also has
preference shares worth Rs. 15000 carrying a dividend of 8%. How does
EPS change if EBIT is Rs. 5000 and Rs. 15000? Tax rate may be taken
as 40% and number of outstanding shares as 1000.
Solution:
Table 6.6 depicts the various changes of EPS if EBIT is Rs. 15,000,
Rs. 10,000, and Rs. 5,000.
Table 6.6: Various Changes of EPS

EBIT 5000 10000 15000

Interest on debt 1250 1250 1250
EBT 3750 8750 13750
Tax 40% 1500 3500 5500
EAT 2250 5250 8250
Preference div. 1200 1200 1200
Earnings available 1050 4050 7050
to equity holders
EPS 1.05 4.05 7.05

Interpretation
 A 50% increase in EBIT from Rs. 10,000 to Rs. 15,000 results in 74%
increase in EPS
 A 50% decrease in EBIT from Rs. 10,000 to Rs. 5,000 results in 74%
decrease in EPS

This example shows that the presence of fixed interest source funds leads
to a value more than that occurs due to proportional change in EPS. The
presence of such fixed sources implies the presence of financial leverage.
This can be expressed in a different way. The Degree of Financial Leverage
(DFL) is a more precise measurement. It examines the effect of the fixed
sources of funds on EPS.

Manipal University Jaipur B1628 Page No. 157

Financial Management Unit 6

DFL = %change in EPS

%change in EBIT

DFL={ΔEPS/EPS} ÷ {ΔEBIT/EBIT}
Or DFL = EBIT ÷ {EBIT—I—{Dp/(1-T)}}
I is Interest, Dp is dividend on preference shares, T is tax rate.

Solved Problem – 7
Kusuma Cements Ltd. has an EBIT of Rs. 5,00,000 at 5000 units of
production and sales. Table 6.7 briefly depicts the capital structure of the
company.
Table 6.7: Capital Structure of the Company
Capital structure Amount
Rs.
Paid up capital 500000 equity shares of 5000000
Rs. 10 each
12% Debentures 400000
10% Preference shares of Rs. 100 each 400000
Total 5800000
Corporate tax rate may be taken at 40%
Solution:
EBIT 500000
Less Interest on debentures 48000
EBIT 452000
DFL= EBIT ÷ {EBIT—I—{Dp/(1-T)}}
500000/(500000—48000—{40000/(1—0.40)}
DFL=1.30
The degree of financial leverage of Kusuma Cements Ltd. is found to be
1.30.

Manipal University Jaipur B1628 Page No. 158

Financial Management Unit 6

Solved Problem – 8
XYZ Enterprises Ltd. has an EBIT of Rs. 2,00,000 at 4000 units of
production and sales. Table 6.8 briefly depicts the capital structure of the
company.
Table 6.8: Capital Structure

Capital structure Amount

Rs.
Paid-up capital 200000 equity shares of 2000000
Rs. 10 each
10% Debentures 500000
5% Preference shares of Rs. 100 each 500000
Total 3000000

Corporate tax rate may be taken at 50%

Solution:
EBIT 200000
Less Interest on debentures 50000
EBIT 150000

DFL= EBIT ÷ {EBIT—I—{Dp/(1-T)}}

200000/(200000—50000—{25000/(1—0.50)}
DFL=2.0
The degree of financial leverage of XYZ Enterprises is found to be 2.0.

6.3.1 Use of financial leverage

Studying the DFL at various levels makes financial decision making on the
use of fixed sources of funds for funding activities easy. One can assess the
impact of change in EBIT on EPS.
Like operating leverage, the risks are high at high DFL. High financial costs
are associated with high DFL. An increase in financial costs implies higher
level of EBIT to meet the necessary financial commitments.

Manipal University Jaipur B1628 Page No. 159

Financial Management Unit 6

A firm which is not capable of honouring its financial commitments may be

forced to go into liquidation by the lenders of funds. The existence of the
firm is shaky under these circumstances.
On one side, the trading on equity improves considerably by the use of
borrowed funds, and on the other hand, the firm has to constantly work
towards higher EBIT to stay alive in the business. All these factors should
be considered while formulating the firm’s mix of sources of funds.
One main goal of financial planning is to devise a capital structure in order
to provide a high return to equity holders. But at the same time, this should
not be done with heavy debt financing which drives the company on to the
brink of winding up.
Impact of financial leverage
Highly leveraged firms are considered very risky and lenders and creditors
may refuse to lend them further to fuel their expansion activities. On being
forced to continue lending, they may do so with their own conditions like
earning a minimum of X% EBIT or stipulating higher interest rates than the
market rates or no further mortgage of securities.
Financial leverage is considered to be favourable till such time that the rate
of return exceeds the rate of return obtained when no debt is used.

Activity:
Coverage R Ltd V Ltd
DOL 2.1 1.5
DFL 1.0 2.2
Comment or leverage of the firms
Hint: R Ltd has more fixed operating costs than V ltd, so its DOL is more.
V Ltd has more fixed financial costs than R ltd, so its DFL is more.

Manipal University Jaipur B1628 Page No. 160

Financial Management Unit 6

Solved Problem – 9
Table 6.9 depicts the balance sheets of two firms – firm A and firm B.
Table 6.9: Balance Sheets of Firms A and B
Balance sheet of A Balance sheet of B
Equity 100000 Assets 100000 Equity 40000 Assets 100000
capital capital
Debt @ 60000
15%
Total 100000 Total 100000 Total 100000 Total 100000

Both the companies earn an income before interest and tax of

Rs. 40000. Calculate the DFL and interpret the results thereof.
Solution:
EBIT
DFL = {EBIT  I  {Dp /(1  T )}}

40000
Company A = 1
40000  0  0
40000
Company B =  1.29
40000  9000  0
The degree of financial leverage of the companies A and B are 1 and
1.29 respectively.
The company, not using debt to finance its assets, has a higher DFL
compared to that of a company using it. Financial leverage does not exist
when there is no fixed charge financing.

6.4 Total or Combined Leverage

The combination of operating and financial leverage is called combined
leverage. Operating leverage affects the firm’s operating profit EBIT and
financial leverage affects PAT or the EPS. These cause wide fluctuations in
EPS. A company having a high level of operating or financial leverage will
find a drastic change in its EPS even for a small change in sales volume.
Companies whose products are seasonal in nature have fluctuating EPS,
but the amount of changes in EPS due to leverages is more pronounced.

Manipal University Jaipur B1628 Page No. 161

Financial Management Unit 6

The combined effect is quite significant for the earnings available to ordinary
shareholders. Combined leverage is the product of DOL and DFL.
Q(S  V )
DTL = Q(S  V )  F  I  {Dp /(1  T )}

Where DTL = Degree of Total Leverage

Solved Problem – 10
Calculate the DTL of Pooja Enterprises Ltd. Table 6.10 depicts the
information regarding the expenses, shares, and sales of the company.
Table 6.10: Details of Pooja Enterprises Ltd.
Quantity sold 10,000 units
Variable cost per unit Rs. 100 per unit
Selling price per unit Rs. 500 per unit
Fixed expenses Rs. 10,00,000
Number of equity shares 1,00,000
Debt Rs. 10,00,000 @ 20% interest
Preference shares dividend 10,000 shares of Rs.100 each @ 10%
Tax rate 50%

Solution:
Q(S  V )
DTL = Q(S  V )  F  I  {Dp /(1  T )}

10000 (500  100 )

10000 (500  100 )  1000000  200000  {100000 / 0.5}

DTL=1.53
Cross verification:
{Q(S  V )}
DOL = {Q(S  V )  F}

10000(500  100 )

10000(500  100 )  1000000

DOL=1.33

Manipal University Jaipur B1628 Page No. 162

Financial Management Unit 6

EBIT = [Q(S-V)-F}

EBIT
DFL= EBIT  I  {Dp /(1  T )}}

3000000
3000000  200000  {100000 / 0.5}
DFL=1.15
DTL=DOL*DFL
1.53 =1.33*1.15
Hence the DTL of Pooja Enterprises Ltd. is 1.54.

Solved Problem – 11
Calculate the DTL of Utopia Enterprises Ltd. Table 6.11 depicts
information regarding the expenses, shares, and sales of the company.
Table 6.11: Details of Utopia Enterprises Ltd.

Quantity sold 20,000 units

Variable cost per unit Rs. 200 per unit
Selling price per unit Rs. 600 per unit
Fixed expenses Rs. 20,00,000
Number of equity shares 1,50,000
Debt Rs. 20,00,000 @ 20% interest
Preference shares dividend 20,000 shares of Rs.200 each
@ 10%
Tax rate 40%

Manipal University Jaipur B1628 Page No. 163

Financial Management Unit 6

Solution:
Q(S  V )
DTL = Q(S  V )  F  I  {Dp /(1  T )}

20000 (600  200)

20000 (600  200)  2000000  400000  {400000 / 0.6}
DTL=1.62
Cross verification:
{Q(S  V )}
DOL= {Q(S  V )  F}
20000(600  200)

20000(600  200)  2000000

DOL = 1.33

EBIT
DFL = EBIT  I  {Dp /(1  T )}}
6000000
6000000  400000  {400000 / 0.6}
DFL=1.22
DTL=DOL*DFL
1.62 = 1.33*1.22
Hence the DTL of Utopia enterprises Ltd. is 1.60

Manipal University Jaipur B1628 Page No. 164

Financial Management Unit 6

Solved Problem – 12
Calculate the DTL of CMA Enterprises Ltd. Table 6.12 depicts
information regarding the expenses, shares, and sales of the company.
Table 6.12: Details of CMA Enterprises Ltd.

Quantity sold 30,000 units

Variable cost per unit Rs. 300 per unit
Selling price per unit Rs. 700 per unit
Fixed expenses Rs. 30,00,000
Number of equity shares 2,00,000
Debt Rs. 30,00,000 @ 30% interest
Preference shares dividend 30,000 shares of Rs.200 each @
20%
Tax rate 30%

Solution:
Q(S  V )
DTL = Q(S  V )  F  I  {Dp /(1  T )}

30000 (700  300)

30000 (700  300)  3000000  900000  {1200000 / 0.7}

DTL=1.88
Cross verification:
{Q(S  V )}
DOL = {Q(S  V )  F}

30000(700  300)

30000(700  300)  3000000
DOL=1.33

Manipal University Jaipur B1628 Page No. 165

Financial Management Unit 6

EBIT
DFL = EBIT  I  {Dp /(1  T )}}

6000000
6000000  900000  {1200000 / 0.7}
DFL=1.77
DTL=DOL*DFL
1.33*1.77=2.35
Hence the DTL of CMA enterprises Ltd. is 2.35

6.4.1 Uses of Degree of Total Leverage (DTL)

 DTL measures the total risk of the company as DTL is a combined
measure of both operating and financial risk
 DTL measures the variability of EPS

Self Assessment Questions

1. __________ arises due to the presence of fixed operating expenses in
the firm’s income flows.
2. EBIT is calculated as _______.
3. Higher operating risks can be taken when ______ of companies are
rising.
4. Dividend on _________ is a fixed charge.
5. Financial leverage is also referred to as ___________.
6. Costs are categorised into _____, ____, and _______.
7. The three types of leverage a company faces are ______, ________,
and __________.

6.5 Summary
Let us recapitulate the important concepts discussed in this unit:
 Leverage is the use of influence to attain something else. The advantage
a company has with the current status of the leverage can be used to
gain other benefits.

Manipal University Jaipur B1628 Page No. 166

Financial Management Unit 6

 There are three measures of leverage – operating leverage, financial

leverage, and total or combined leverage.
 Operating leverage examines the effect of change in quantity produced
upon EBIT and is useful to measure business risk and production
planning. Financial leverage measures the effect of change in EBIT on
the EPS of the company. It also refers to the debt-equity mix of a firm.
 Total leverage is the combination of operating and financial leverages.

6.6 Glossary
Capital structure: The permanent, long-term financing of a company
represented by a mix of long-term debt, preference shares, and net-worth.
Combined leverage: The combination of operating and financial leverage.
Financial leverage: A firm's use of fixed-charge securities like debentures
and preference shares in its plan of financing the assets.
Fixed costs: The costs which do not vary with an increase in production or
sales activities for a particular period of time.
Leverage: The use of an asset or source of funds for which the company
has to pay a fixed cost or fixed return.
Operating leverage: The degree to which a firm has built-in fixed costs
due to its particular or unique production process.
Semi-variable costs: Costs which are partly fixed and partly variable in
nature.
Variable costs: Costs which vary in direct proportion to output and sales.

Manipal University Jaipur B1628 Page No. 167

Financial Management Unit 6

6.7 Solved Problems

13. Table 6.13 depicts the information which has been collected from
the annual report of Garden Silks. What is the degree of financial
leverage?
Table 6.13: Annual Report of Garden Silks

Total sales Rs. 14,00,000

Contribution ratio 25%
Fixed expenses Rs. 1,50,000
Outstanding bank loan Rs. 4,00,000 @ 12.5%
Applicable tax rate 40%

Solution:
DFL = EBIT / (EBIT-I) = 200000/200000-50000 = 1.33
EBIT = Sales*25% less fixed expenses
1400000*25% = 350000-150000 = 200000
14. Suppose X and Y have provided the information regarding the sales
and the cost of their expense. Table 6.14 depicts the information.
Which firm do you consider to be risky?
Table 6.14: Information of X and Y
X Ltd. Y Ltd.
Sales in units 40000 40000
Price per unit 60 60
Variable cost p.a. 20 25
Fixed financing cost Rs. 100000 Rs. 50000
Fixed financing cost Rs. 300000 Rs. 200000

Solution:
DOL = Q(S-V) / Q(S-V)-F
Company X: 40000(60-20) / 40000(60-20)-400000
1600000/1200000 = 1.33
Company Y: 40000(60-25) / 40000(60-25)-250000
1400000/1150000= 1.22

Manipal University Jaipur B1628 Page No. 168

Financial Management Unit 6

15. Calculate EPS. Table 6.15 depicts the information of a firm.

Table 6.15: Information of a Firm
EBIT Rs. 11,80,000
Interest Rs. 2,20,000
No. of outstanding shares 40,000
Tax rate applicable 40%

Solution:
Table 6.16 depicts the calculated earnings per share.
Table 6.16 Earnings Per Share
EBIT Rs. 11,80,000
Less interest Rs. 2,20,000
EBT 9.60,000
Tax @ 40% Rs. 3,84,000
EAT Rs. 5,76,000

EPS = EAT/no of shares outstanding

576000/40000 = Rs. 14.4
16. Table 6.17 depicts the leverages of three firms. Which one of the
combinations should be chosen for the combined leverage to be the
maximum and what are the inferences?
Table 6.17: Leverages of Three Firms

A B C
Operating leverage 1.14 1.23 1.33
Financial leverage 1.27 1.3 1.33

Solution:
We should calculate the combined leverage to draw inferences.
Combined leverage of A is 1.14*1.27 = 1.45,
Combined leverage of B is 1.23*1.3 = 1.60,
Combined leverage of C is 1.33*1.33 = 1.77
We find that the combined leverage is highest for firm C and this suggests
that this firm is working under very high risky situation.

Manipal University Jaipur B1628 Page No. 169

Financial Management Unit 6

6.8 Terminal Questions

1. Table 6.18 depicts the information provided by Mishra Ltd. What is the
degree of operating leverage?
Table 6.18: Details of Mishra Ltd.

Output 25,000 units

Fixed costs Rs. 15,000
Variable cost per unit Rs. 0.50
Interests on borrowed funds Rs. 15,000
Selling price per unit Rs. 1.50

2. Table 6.19 depicts the information provided by X Ltd. What is the degree
of financial leverage?
Table 6.19: Details of X Ltd.

Output 25,000 units

Fixed costs Rs. 25,000
Variable cost Rs. 2.50 per unit
Interest on borrowed funds Rs. 15,000
Selling price Rs. 8 per unit
3. Table 6.20 depicts the sales, costs, and interests of two firms. Comment
on their relative performance through leverage?
Table 6.20: Sales and Costs of Two Firms A and B

A Ltd. (Rs. In lakhs) B Ltd. (Rs. In lakhs)

Sales 1000 1500
Variable cost 300 600
Fixed cost 250 400
EBIT 450 500
Interest 50 100

Manipal University Jaipur B1628 Page No. 170

Financial Management Unit 6

4. Table 6.21 depicts the information provided by ABC Ltd. regarding the
cost, sales, interests, and selling prices. Calculate the DFL.
Table 6.21: Details of ABC Ltd.

Output 20,000 units

Fixed costs Rs. 3,500
Variable cost Rs. 0.05 per unit
Interest on borrowed funds Nil
Selling price per unit 0.20

6.9 Answers

Self Assessment Questions

1. Operating leverage
2. Q(S—V)—F
3. Income levels
4. Preference shares
5. Trading on Equity
6. Fixed costs, variable costs, and semi-variable costs.
7. Operating leverage, financial leverage, and combined leverage.

Terminal Questions
{Q(S  V )}
1. Hint DOL =
{Q(S  V )  F}
EBIT
2. Hint DFL = {EBIT  I  {Dp /(1  T )}}

3. Hint calculate DFL

EBIT
4. Hint calculate DFL =
EBIT  I  {Dp /(1  T )}}

6.10 Case Study: Leverage

Financial Leverage is something you need to watch carefully. As with any
kind of debt, a judicious amount can boost returns, but too much can lead to
disaster. Look at the kind of business a firm is in. If it's fairly steady, a

Manipal University Jaipur B1628 Page No. 171

Financial Management Unit 6

company can probably take on large amounts of debt without too much risk
because there's only a small chance of the business falling off a cliff and the
company being caught short when bondholders demand their interest
payments. On the flip side, be very wary of a high financial leverage ratio if a
company's business is cyclical or volatile. Because interest payments are
fixed, the company has to pay them whether business is good or bad.
Following is an excerpt from the stock analysis of Opto Circuits. The entire
analysis is available on
Opto Circuits is a small company in medical electronics industry with focus
in the niche areas of invasive (coronary stents) and non-invasive (sensors,
patient monitors) segments. Prior to '2002, Opto's revenues were less than
Rs. 50 crore. Today revenues stand at Rs. 468 crore with exports
accounting for more than 95% of revenues. Opto Circuits is based in
Bangalore, India and operates out of offices established in the USA, Europe,
South-East Asia, Latin America, and the Middle East and boasts of a strong
international distribution network present in over 70 countries.
Opto Circuits Profitability Snapshot

Manipal University Jaipur B1628 Page No. 172

Financial Management Unit 6

As one can see from above, net profit margins are healthy (over 28%), great
return on equity and solid return on invested capital ratios (over 45%).
Financial health has been steadily improving over the years with
comfortable financial leverage (1.34) and Debt to equity (0.31), with solid
current and quick ratios. However, Opto Circuits still has a long way to go
before it can show loads of excess cash in its books due to its aggressive
business expansion. Free cash flow as a percentage of sales is ~6%. It has
consistently increased dividends per share and has a unique track record of
rewarding shareholders with bonus shares every year for the 7th straight
year.
There are these 3 levers that can boost Return on Equity (ROE) - net
margins, asset turnover, and financial leverage. (Because ROE = Net
Margin x Asset Turnover x Financial Leverage).
Opto Circuits has shown steady improvements on net margin front but
recorded a quantum jump from ~16% in FY05 to over 27% in FY06. It has
since maintained net margins at around 27-29%. While asset turnover has
dipped in recent years before recovering somewhat in FY08, high net
margins have compensated for return on assets steadily improving from
around 14% in FY 2002 to almost 30%.
Opto Circuits has done even better with respect to the efficiency of using
shareholder’s equity with ROE improving from about 20% in FY02 to 40%.
What has boosted ROE in the last few years is consistent net margin
improvements and decent use of financial leverage.
Can we dig deeper to see what else we can understand about how Opto
Circuits makes money? A good way is to look at the common size profit and
loss statement. Common size statements are great tools for evaluating
companies because they put every line item in context by looking at each of
them as a percentage of Sales.

Manipal University Jaipur B1628 Page No. 173

Financial Management Unit 6

The numbers show some consistent trends. Gross Margins have improved
over the years from over 33% in FY02 to over 40% in FY 08. Spending on
overheads - selling and operating expenses - after rising in the initial years
is now showing signs of increasing efficiencies – perhaps due to increasing
synergies and rationalisation in Opto’s distribution network - declining to
about 12% in FY08 from about 18% in FY05.
Overall, we see a company that is achieving increasing control over cost of
goods sold and showing signs of becoming more efficient in terms of
overhead spending.
Once we have figured out how fast (and why) a company has grown and
how profitable it is, we need to look at its financial health.
Opto Circuits Financial Health Snapshot

Performance of Opto Circuits

A review of the last 7 years with respect to Opto Circuits Management
performance is heartening. Return on assets has improved from around
14% in FY02 to almost 30% in FY08. ROE in FY08 is 40% - the highest
ROEs in the medical electronics industry - from 20% in FY02. The fact that
this has been achieved, at Opto Circuits’ scorching pace of growth, without
resorting to excessive financial leverage is commendable.
(Source : www.stock-picks-focus.com)
Discussion Questions:
1. Explain how you think the company has used its financial leverage?
(Hint Refer to financial leverage)
2. A company considered too highly leveraged may find its freedom of
action restricted. Do you agree?
(Hint Refer to financial leverage)
Manipal University Jaipur B1628 Page No. 174
Financial Management Unit 6

3. What do you think is the association of leverage with business risk?

(Hint Refer to leverage)
4. The result of the analysis of the stock in this case is positive. How much
credit in this regard would you attribute to the company’s use of financial
leverage?
(Hint Refer to financial leverage)
5. What is your understanding on the relationship between financial
leverage and Return on Equity?
(Hint Refer to combined leverage)
(Source: http://www.stock-picks-focus.com/opto-circuits.html#Profitability-
Snapshot)

References:
1. Pandey, I. M., (2005), Financial Management, Vikas Publishing House
2005, 9th edition
2. Prasanna, Chandra (2007), Financial Management: Theory and Practice,
7th Edition, Tata McGraw Hill.
E-Reference:
 http://www.stock-picks-focus.com/opto-circuits.html#Profitability-
Snapshot retrieved on 11-12-2011.

Manipal University Jaipur B1628 Page No. 175