1904,78

Financial
Management
4612.00

LEVERAGES
7 Chapter

Learning Objectives
After studying this chapter, you should be able to understand:
T h e meaning and types ofleverages in business.
Financial leverage and its impact on EPS.

Operating leverage.
Combined leverage.
Degree of leverages.

MEANING AND TYPES

A general dictionary meaning of the term 'Leverage' refers to "an increased means of
certain things which are otherwise
pshing some purpose." Leverage allows us to accomplish
This concept of leverage is valid inn
pOssible, viz; lifting of heavy objects with the help of leverage.
used to describe the firm's ability to use
f Saso. In financial management, the term 'leverage' is i.e. shareholders. James Horne
COst assets or funds to increase the return to its owners; equity
of funds for which the firm has to
e d leverage as "the employment of an asset or sources
n
pay
e d cost or fixed return." The fixed cost (also called fixed operating cost) and fixed return
(called i in volume of output or sales. Thus,
ancial cost) remains constant irrespective of the change return has
a ployment
acons
of an asset or source of funds for which the firm has to pay a fixed cost or
as tha
de Ole influence on the earnings available for equity shareholders. The fixed cost/return acts
and the leverage mn
leverage magnifies the influence. It must, however, be noted that higher is the
degr ee um
of ge, higher is the risk as well as return to the owners. It should also be remembered
at eVer leverage,
leverage
6 can have negative
an
nega or reversible effect also.
It may be favourable or unfavourable.
There are
basically two types of leverages
)operating leverage, and
i) financial leverage.
 7.2

The leverage associated with the employment of fixed cost assets is referred to as
Leverages
leverage, while the leverage resulting from the use of fixed cost/return source of funds is n
financial leverage. In addition to these two kinds of leverages, one could always conmpute'comna
leverage to determine the combined effect of the leverages. In the present days, the term leva
also used in relation to working capital so as to measure the
sensitivity of return on investmo
changes in the level of current assets. All these of
types leverages are discussed in the following nao
of this chapter. es

1 . FINANCIAL LEVERAGE
ORTRADING ON EQUITY
A firm needs funds so run and
manage its activities. The funds are first needed to set upan
enterprise and then to implement
expansion, diversification and other plans. A decision has to he
made regarding the
composition funds. The funds may be raised through two sources : owners
of
called ouwners equity, and outsiders, called creditor's
owners' funds, when it raises, funds
equity. When a firm issues capital theseare
by raising long-term and short-term loans it is called creditors
or ourtsiders' equity. Various means used to raise funds
represent the financial structure of a firm.
the financial structure is So
represented by the left side of the balance sheet i.e. liabilities side.
Traditionally, the short-term finances are excluded from the methods of
decisions. so, only long term sources are taken as a financing capital budgeting
part of capital structure. The term
structure' refers to the
relationship between various long-term forms of financing such as debentures, capital
preference share capital, equity share capital, etc. Financing the firm's assets is a
in very business and as a very crucial problem
of long-term fixed interest
general rule there should be
proper mix of debt and equity capital. The use
bearing debt and preference share
capital along with equity share
capital is called financial leverage or trading on equity. The
employed by a firm to earn more from the use of these resources long-term fixed interest bearing debt is
return on owner's
than their cost so as to increase the
equity. It is true that the capital structure cannot affect the total
but it carn affect the share of earnings of a hirm
earnings for equity shareholders.
The fixed cost funds are
employed in such a way that the earnings available for commot
stockholders (equity shareholders) are increased. A fixed
rate of interest is paid on such
and nmust be paid irrespective of revenue long-tert
debts (debentures, etc.). The interest is a
The preference share liability earning
capital also bears a fixed rate of dividend. But, the dividend is
the company has surplus
profits. The equity shareholders are entitled to residual income paid only wnet
interest and preference dividend. The aim of ater pay
financial leverage is to increase the revenue
equity shareholders using the fixed cost funds. If the revenue availab
earned by employing fixed
is more than their cost (interest
and/or preference dividend) then it will be to the benefitcost or
r
shareholders to use such a capital structure. A firm is e
known to have a
earnings are more than what debt would cost. On the contrary, if it doesfavourable not
leverage he
earm as mu
the
debt costs then it will be known as an unfavourable
leverage.
Every firms has to make its own decision
regarding the quantum of funds to wed.
When

the amount of debt is relatively large in relation to be baorroding 0n

said to be trading on
their equity. On the other hand if the amount of debt capital stock, a is
company said to al stock stock

is comparatively low in relation to

the company is said to be trading on thick capita
equity.
IMPACT OF FINANCIAL LEVERAGE
the

The financial leverage is used to

magnify the shareholders earnings. It is Dan's rate
assumption that the fixed charges/costs funds can be obtained at a cost lower than te
 7.3
Leverages
financed by fixed cost
onits assets. When the difference between the earnings from assets
pf return will get additional
and the costs funds are distributed to the equity stockholders, they
of these
funds
funds and
share and the rate
ithout increasing
earnings with their own investment. Consequently, earnings per the at
fixed cost funds
on equity capital will go up. On the contrary, if the firm acquires
share
of return share and return
on equity
cost than the earnings from those assets then the earnings per
a higher
while looking at earnings per
capital will decrease. The impact of financial leverage can be analysed
share and
return on equity capital.
their
view to examining
A firm is considering two financial plans with a
ILLUSTRATION 1. investment in assets are 5,00,000.
Per Share (EPS). The total funds required for
impact on Earnings
Financial Plans
Plan II
Plan I
1,00,000
4,00,000
Debt (Interest
10% p.a.) 1.00.000
400.000
10 each)
Equity Shares (R 5.00.000
5.00,000
Total finances required 40,000
10,000
shares
No. of equity
75,000 and 1,25,000. The rate of
before interest and tax are assumed as 7 50,000, 7
The earnings
50%. Comment.
tax be taken at

SOLUTION

(EBIT) are 50,000

Interest and Tax
(1) When Earnings Before
Plan I Plan II

50,000 50,000
interest and tax (EBIT) 10,000
Earnings before 40,000
Less: Interest on debt 10,000 40,000
20,000
Earnings before tax (EBT) 5,000
Less: Tax50% 5,000 20,000
and tax 40,000
Earnings after interest 10,000
No. of equity shares 20,000 0.50 P
5,000 =0.50 P 40,000
10,000
Earnings per share (EPS)
When EBIT is 75,000
(2) Plan I Plan 1I

75,000 75,000
40,000 10,000
EBIT
Less: Interest on debts 35,000 65,000
17,500 32,500
EBT
17,500 32,500
Less: Tax 50%
40,000
Earnings after interest and tax 10,000
1.75 0.81
No. of equity shares
Earnings per share (EPS)
 7.4
Leverages
(3) When EBITis 1.25,000
Plan I Plan II

EBIT 1,25,000 1,25,000

Less: Interest on debts 40,000 10,000
EBT 85,000 1,15,000
Less: Tax @ 50 42,500 57,500
Earnings after interest and tax 42,500 57,500
No. of equity shares 10,000 40,000
Earnings per share EPS 4.25 1.438

Comments
(1) Plan I is a
leveraged financial plan because it has 80% debt financing and has only 20%o equity
financing. Plan lI is a conservative financial plan where fixed cost funds are only 20% of total funds
and the rest is financed through
equity capital.
(2) The EPS is increasing in Plan I with the increase in profits (EBIT). In situation
(1) the earnings
per share is same in both the plans i.e., Re. 0.50. As the EBIT has increased from F 50,000 to
75,000
(situation 2) the EPS in plan I is 1.75 while it is 0.81 in plan II. EPS is in Plan I and 7 7 4.25
Plan II when EBIT increases to 1,25,000 1.438 in
(3) It is a clear from the analysis that EPS is increasing with the increase in
profits in Plan I as
compared to that of Plan II. This is possible with the use of more fixed cost funds in plan as
compared to Plan II.
(4) The increase in EPS in Plan I is due to the financial leverage because earnings before interest
and tax are same in all the situation.
ILLUSTRATION 2. A Ltd. Company has equity share capital of 5,00,000 divided into shares o
7 100 each. It wishes to raise
further 3,00,000 for expansion cum modernisation plans. The company
plans the following financing schemes.
(a) All common stock
(b) one lakh in common stock and two lakh in
10% debentures.
(c) All debt at 10% p.a.
(d)one lakh in common stock and two lakhs in
at 8%. preference capital with the rate of divide
The company's
expected earnings before interest and tax (EBIT)
of tax is 50%. are 1,50,000. The corporate ra
You are
required to determine the earnings per share
(EPS) in each plan and comment on the
implications of financial leverage.
SOLUTION:
Plan I Plan ll Plan IV
Plan ll
Earnings before interest and tax
Less: Interest 1,50,000 1,50,000 1,50,000
1,50,000
20,000 30,000
1,50,000 1,30,000 1,20,000
1,50,000
 7.5
Leverages

Less: Tax 5 0 %
75,000 65,000 60,000 75,000
Earnings after tax 75,000 65,000 60,000 75,000
Preference
dividend 8% 16,000
Less: stockholders
ers 75,000 59,000
railable for common
65,000 60,000
Earnings
shares 8,000 6,000 5,000 6,000
No. ofcommon
Earnings pershare T 9.375 10.83 12 9.83

Comments

In the four plans of fresh financing, Plan II is the most leveraged of all. In this case additional
Enancing is done by raising loans ® 10% interest. Plan II has fresh capital stock of R one lakh while
wa lakhs are raised from loans. Plan IV does not have fresh loans but preference capital has been
two lakhs.
raisedfor
cost funds and
The earnings per share is highest in Plan IIlie. R 12. This plan depends upon fixed
Plan II is next best
common stockholders by increasing their share in profits.
thus has benefited the
scheme where EPS is 10.83. In this case too 2 lakhs are raised through fixed cost funds. Even in
Plan IV, where preference capital of ? 2 lakhs is issued, it is better than Plan I where common stock of
3 lakh is raised.
The analysis of this information shows that financial leverage has helped in improving earnings
to equity the
per share for equity shareholders. It helps to conclude that higher the ratio of debt
greater the return for equity stockholders.

Impact of Leverage on Loss

If a firm suffers losses then the highly leveraged scheme will magnify the losses per share. This
impact is discussed in illustration 3.
ILLUSTRATION 3. Taking the figures in Ilustration 2, a concern suffers a loss of 7 70,000.
Discuss the impact of leverage under all the four plans.
SOLUTION
PlanI Plan II Plan III Plan IV

Loss before interest and tax -70,000 -70,000 -70,000 -70,000

Add: interest
Loss after interest
20,000 30,000
-70,000 -90,000 -1,00,000 -70,000
No. of
Equity (common) Shares 8,000 6,000 5,000 6,000
Loss per share 8.75 15 20 11.67
Comments
o s s per share is highest in Plan II because it has the higher debt-equity ratio while it is
an adn Plan I because all additional funds are raised through equity capital. The leverage will have
lOsSe mpact on earnings if the firm suffers losses because fixed cost securities will magnify the

a)20LLUSTRATION
20% before 4.
ATON 4.
tax rate
Calculate EPS (earning per share) of Shy Ltd. and Smart Ltd. assuming
ra' of return on assets (b) 10% before tax rate of return on assets based on the
following data :
 7.6

Shy Ltd.
Leveragen
Smart Ltd.
(in lakhs) (7in lakhs)
Assets 200
200
Debt (12o) 100
Equity 200 100
(Shares of 7 10 each)
(Shares of ? 10 each
Assume a 50% income tax in both cases. Also give your comments on the financial leverage

SOLUTION:
Calculation of EPS (Earnings per share)
(in lakhs)
Shy Ltd. Smart Ltd.
20% 10% 20% 10%
EBIT (Earmings before interest and tax) 40 20 40 20
Less: Interest (12%
on debt) 12 12
Earnings after interest but before tax 40 20 28
Less: Tax (50%) 20 10 14
EAT (Earnings after tax 20 10 14
Number of equity shares in lakhs 20 20 10 10
EPS (Earnings per share in ) 1.00 0.50 1.40 040

Comments : Smart Ltd. has used debt in its financing, as such when the rate of return is 20o
(higher than the cost of debt), its EPS is higher than that of Shy Ltd. which does not use any debt. But
when the financial leverage is unfavourable at 10% rate of return (the cost of debt is higher), there is
a negative
impact of leverage and the EPS has decreased.
Degree of Financial Leverage
The degree of financial leverage measures the impact of a
change in operating income (EBI) en
change in earning on equity capital or on equity share. Degree of financial leverage DFL can e
calculated as:

DFL=
Percentage change in EPS
Percentage change in EBIT
or

EBIT
DFL
EBT (or, EBIT-1)

JLLUSTRATION5 ting
XYZ Company has currently an equity share capital of ? 40 lakhs consist
to
of 40,000 equity shares of 100 each. The management is planning to raise another 30 lak
finance a major programme of expansion through one of the four possible financing plans.
The options are:
(i) Entirely through equity shares.
(ii) 15 lakhs in equity shares of 100 each and the balance in 8% Debentures
 7.7
Leverages

alakhs in equity shares of 100 each and the balance through long-term borrowing at
(ii)
9% interest p.a.
1 5 lakhs in equity shares ofR 100 each and the balance through preference shares with 5%
dividend.

apany's expected earning before interest and taxes (EBIT) will be ? 15 lakhs. Assuming
The c o m p a n y ' s e x

bo tax rate of 50%, you are required to determine the EPS and comment on the financial
corporateta

will be authorised under each of the above scheme of financing.

leverage that will

sOLUTION
Calculation of EPS and Financial Leverage
Financial Financial Financial Financial
Plan Plan Plan Plan
I II III IV

(R in lakhs)
Shares 40+30 70 40+15 55 40+10-50 40+15 55
Equity
Equity Shares (Number) 70,000 55,000 50,000 55,000
8% Debentures i n lakhs) 15
9% Long-ternm Borrowings ( in lakhs) 20
Preference Shares (R in lakhs) 15
Earnings before interest and tax

EBIT) 15,00,000 15,00,0000 15,00,000 15,00,000

Less: Interest on debentures (1,20,000)
Interest on long term borrowing (1,80,000)
Earnings before tax 15,00,000 13,80,000 13,20,000 15,00,000
Less: Tax @ 50% 7,50,000 6,90,000 6,60,000 7,50,000
Earmings after tax (EAT) 7,50,000 6,90,000 6,60,000 7,50,000
Less: Preference dividend 75,000
Earmings for equity shareholders 7,50,000 6,90,000 6,60,000 6,75,000
Number of equity shares 70,000 55,000 50,000 55,000
Eamings per shares (EPS) 10.71 12.55 13.20 12.27
Degree of Financial Leverage (DFL) 1.00 1.087 1.136 1.00
EBIT
EBIT-I)
Comments
nce
should
the EPS as well as degree of financial leverage (DFL) is highest in plan
financial I, it

be ugh
accepted. The company should raise 10 lakhs in equity shares and the balance of 20
long-term borrowing at 9% interest p.a.

Significance or Advantages of Financial Leverage

shareFinancial
a l leverage is employed to plan the ratio between debt and equity so that earning Pper
nproved. Following is the
significance of financial leverage:
anning of Capital Structure. The capital structure is concerned with the raising of long-
m funds, both from shareholders and long-term ereditors. A financial manager has to
decide
Dout the ratio between fixed cost funds and equity share capital. The effects of
 7.8
borrowing on cost of capital and financial risk have to be discussed before
Leverages
efore selectine
selecting fina
a
capital structure.
2. Profit Planning. The earning per share is affected by the degree of financial leverage t.
If the
profitability of the concern is increasing then fixed cost funds will help in increasino
ing he
availability of profits for equity stockholders. Therefore, financial leverage is importan
o
profit planning. The level of sales and resultant profitability is helpful in profit plannis
An important tool of profit planning is break-even analysis. The concept of ining,
analysis is used to understand financial leverage. So, financial leverage is
break-even
very importat.
for profit planning.

Limitations or Disadvantages of Financial Leverage/Trading on Equity

The financial leverage or trading onequity suffers from the following limitations
1. Double-edged weapon. Trading on equity is a double-edged weapon. It can besucesstull
employed to increase the earnings of the shareholders only when the rate of earnings of the
company is more than the fixed rate of interest/ dividend on debentures/preference
shares. On the other hand, if it does not earn as much as the cost of interest bearing
securities, then it will work adversely and hence cannot be employed.
2. Beneficial only to companies having stability of earnings. Trading on equity is benefical
only to the companies having stable and regular earnings. This is so because interest on
debentures is a recurring burden on the company and a company having irregular income
cannot pay interest on its borrowings during lean years.
3. Increases risk and rate of interest. Another limitation of trading on equity is on account of
the fact that every rupee of extra debt increases the risk and hence the rate of interest on
subsequent loans also goes on increasing. It becomes difficult for the company to obtain
further debts without offering extra securities and higher rates of interest reducing their
earnings.
4. Restrictions from financial institutions. The financial institutions also impose restrictions
on companies which resort to excessive trading on equity because of the risk factor and to

maintain a balance in the capital structure of the company.

2 . OPERATINGLEVERAGE
Operating leverage results from the presence of fixed costs that help in magnifying net operatng
income fluctuations flowing from small variations in revenue. The fixed cost is treated as fulerum
with
a leverage. The changes in sales are related to changes in revenue. The fixed costs do not change
ting
the change in sales. Any increase in sales, fixed costs remaining the same, will magnify the operatn
ered
revenue. The operating leverage occurs when a firm has fixed costs which must be recove
ating
irrespective of sales volume. The fixed costs remaining same, the percentage change in opera
revenue will be more than the percentage change is sales. The occurrence is known as o
leverage. In the words of Ezra Solomon, "The term operating leverage refers to the sensitnvd
operating profits to sales." The degree of operating leverage depends upon the amount o
elements in the cost structure. ofit

Operating leverage can be determined by means of a break even or cost volume

analysis.
Leverages
7.9
will be calculated
Theoperating leverage
as

Operating Leaverage
Contribution
Operating Profit
Contribution =
Sales -

Variable cost
Operating Profit
Sales-VariableCost- Fixed cost
or O.P. =
Contribution -

Fixed Cost
The break even point can be calculated by dividing the fixed cost by percentage of contribution to
sales or P/V Ratio.

Fixed Cost
Break Even Point P/V Ratio
P/V Ratio =Contribution
Sales
When production and sales move above the break even point, the firm enters highly profitable
range of activities. At break even point the fixed costs are fully recovered, any increase in sales
beyond this level will increase profits equal to contribution. A firm operating with a high degree of
leverage and above break even point earns good amount of profits.
If a firm does not have fixed costs then there will be no operating leverage. The percentage
change in sales will be equal to the percentage change in profit. When fixed costs are there, the
percentage change in profits will be more than the percentage in sales volume.
Thus, degree of operating leverage can be computed as below:

Degree of Operating Leverage Percentage Change in Profits

Percentage Change in Sales

LLUSTRATION 6. Following is the cost information of a firm:

Fixed cost = 7 50,000
Variable cost 70% of sales
Sales= 2,00,000 in previous year and 2,50,000 in current year.
Find out percentage change in sales and operating profits when:
(i) Fixed costs are not there (no leverage)
(ii) Fixed cost are there
(leveraged situation).
SOLUTION
(i) PreviouS year Current year Percentage Change
Sales 2,00,000 2,50,000 25%
Less:
Variable cost (70% of sales) 1,40,000 1,75,000 25%
Profit from operations 60,000 75,000 25%
(ii)
Previous year Current year Percentage Change
Sales
2,00,000 2,50,000 25%
Less: Variable cost (70% of 1,40,000 1,75,000 25%
sales)
 7.10

Contribution 60,000 75,000

Leveranen
25%
Less: Fixed cost 50,000 50,000
Profit from operations 10,000 25,000 150%
Comments
(1) In situation (i) where there are no fixed costs (or absence of leverage) the percentage cha-
in sales and percentage change in operating profit is the same i.e. 25%. change
(2) In situation (ii) where there are fixed costs, the leverage being occurring, the percents
change in profits (150%) is much more than the percentage change is sales (25%). ntage
(3) The fixed cost element has helped in magnifying the percentage increase in operating profits
Significance or Advantages of Operating Leverage
1. Tool of Financial Analysis. Operating leverage is generally used as a tool of financial
analysis. The analysis of operating leverage is used for financial decision making.
2. Impact of Changes in Sales on Level of Operating Profits. Operating leverage is calculated
to determine the impact of changes in sales on the level of operating profits.

ORisk Factoror Limitations

It is true hat a high leveraged situation will magnify the operating profits but it brings in the risk
element too. The percentage change in profits will be more in a situation with higher fixed costs as
comparted to that where fixed costs are lower. The higher degree of leverage brings in more decrease
in operating profits. This situation can be illustrated with the help of the following illustration.

ILLUSTRATION 7. Following information is taken from the records of hypothetical company

a

Installed capacity 1,000 units

Operating capacity 800 units
Selling price per unit 10
Variable cost per unit 77

Calculate operating leverage under the following situations:

Fixed cost:
SituationssA
Situation B ,200
SituationC 1,500

SOLUTION
Situation C
SituationA SituationB

8,000
Sales 8,000 8,000
5,600

Less: Variable cost 5,600 5,600 400

Contribution (C) 2,400 2,400

1,500
Less: Fixed Cost 800 1,200
(F)
Leverages
7.11

Operating Profit (OP) 1,600 1,200 900

Operating Leverage 24001,200 2,400+ 900
2,400+1,600
2.67
(C
(OP
1.5 2.0

Break Even Point (BEP)

2,667 4,000 5,000

Margin of Safety Ratio

66.7% 50% 37.5%

Percentage of sales at break even point 33.3% 50% 62.5%

A 10 per cent increase in sales would be accompanied by an increase in operating profits of 15%
in situation A, 20% in situation B and 26.7% in situation C. Situation C is of high operating leverage
since the operating profit will increase by one 2/, times (26.7% for every 10% increase in Sales). This
is high risk situation too because a small decrease in sales will result in more decrease in profits.
The margin of safety ratio is 66.7% in situation A which means that a sales decrease of this
percentage wil bring the firm to break even point (no proit no loss point). This
C is
ratio
in situation
only 37.59% which means that the company can reach the break even situation much more early as
compared to situation A. Taking the percentage of sales at break even point, it will reach at 33.3% of
sales in situation A, 50% in situation B and 62.5% in situation C. In situation A the company will start
in
earning profit at an early stage of sales while in situation C it will reach only beyond 62.5%
situation C. In situation A the company will start earning profit at an early stage of sales while in
situation C, it will reach only beyond 62.5% of sales.
A high operating leverage (situation C) has lwo margin of safety and has thin cushion for

absorbing shocks whereas situation of low operating leverage (situation A) has higher margin of
a
safety ratio. This situation is less risky because any decrease in sales will not bring down the profits at
a higher rate. It can be concluded that a high leveraged situation brings in more profits with the
increase in sales but at the same time it brings in more risk to00.

3 . COMPOSITE LEVERAGE
Both financial and operating leverage magnify the revenue of the firm. Operating leverage
affects the income which is the result of production. On the other hand, the financial leverage is the
result of financial decisions. The composite leverage focuses attention on the entire income of the
concern. The risk factor should be properly assessed by the management before using the composite
leverage. The high financial leverage may be offset against low operating leverage or vice-versa.
Ihe degree ofcomposite leverage can be calculated as follows:

Degree of Composite Leverage (D

Percentage Changein EPS
Percentage Change in Sales

Or, Composite Leverage = Operating Leverage x Financial Leverage

LUSTRATION 8. A company has sales of ? 5,00,000, variable costs of R 3,00,000, fixed costs of
D a n d long-term loans of 7 4,00,000 at 10% rate of interest. Calculate the composite leverage.
7.12
Leverages
SOLUTION:
Contribution
() Operating Leverage Earning before interest and tax

2,00,000 -2
1,00,000
Sales-Variable cost- Fixed cost
(i) Financial Leverage Sales - Variable cost- Fixed cost - Interest

5,00,000-7 3,00,000-7 1,00,000

F 5,00,000- 3,00,000- 1,0,000 - R 40,000

= 1,00,000
60,000

(Gi) Composite Leverage = Operating Leverage x Financial Leverage = *

LLUSTRATION 9. A simplified income statement of Zenith Lid. is given below. Caleulate and
interpret its degree of operating leverage, degree of financial leverage and degree of combined
leverage.
Income Statement of Zenith Ltd. for the year ended 31st March2019.

Sales
10.50.000
Variable Cost 7,67,000
Fixed Cost 75.000
EBIT 2,08,000
Interest 1,10,.000
Taxes (30%) 29.400
Net Incomne 68,60

sOLUTION
(a) Operating Leverage Contribution
Earnings before interest and tax
Contribution =
Sales -Variable Cost= 10,50,000-7,67,000
=72,83,000
EBIT 208,000 (given)

Operating Leverage = Z83,0003

2,08,000.3

Interpretation: Operating leverage of 1.36 indicates that 1% change in sales is likely to result in 1.36%
change in earnings before interest and tax.

(b) Financial Leverage Earnings before interest and tax

Earnings before tax
EBIT =72.08,000 (given)
EBT EBIT - Interest= F2,08,000-1,10,000 98,000
=
 Leverages 7.13

Financial Leverage = 2,08,000 = 2.12

98,000
Interpretation: The financial leverage of 2.12 indicates that 1% change in EBIT is likely to cause a
change of 2.12% in the net income of the company.

(c) Combined Leverage =

Operating leverage x Financial Leverage
=
1.36 x 2.12 2.88
Interpretation : Combined leverage of 2.88 indicates that 1% change in sales is Iikely to resuit in 2.88
change in net income of the company.

ILLUSTRATION 10. The following figures relate to two companies.

PLTD QLTD
(In lakhs)

Sales 500 1,000

Variabie costs 200 300
Contribution 300 700
Fixed costs 150 400
150 300
Interest 50 100
Profit before Tax 100 200
You are required to
i) calculate the operating, financial and combined leverages for the two companies ; and
(ii) comment on the relative risk position of them.

sOLUTION:
i) Calculation of Leverages
P Ltd. Q Ltd.

(a) Operating Leverage Contribution 300 700

Earnings before interest and tax 150 300

= 2333

(b) Financial Leverage Earnings before interest and tax 150 300
Earnings before tax 100 200

1.5 .5
(c) Combined Leverage
= OLx FL Contribution 300 700
Or
Profit before tax 100 200
= 3.5

) Comments on the Relative Risk Position

(a) Operating Leverage. As the operating leverage for Q Ltd. is higher than that of P. Ltd; Q
Ltd. has a higher degree of operating risk. The tendency of operating profit to vary
disproportionately with sales is higher for Q Ltd. as compared to P. Ltd.
 7.14
Leverages
(b) Financial Leverage. Since finance leverage for the two companies is the same, both the
companies have the same degree of financial risk, i.e. the tendency of net disproportionatal

is the same for P. Ltd. and Q Ltd.

(c) Combined Leverage. As the combined leverage for Q Ltd. is higher than P Ltd; Q Ltd h
has
overall higher risk as compared to P Ltd.
ILLUSTRATION11 A firm has sales of 20,00,000, variable cost of 14,00,000 and fixed costs of
4.00.000 and debt of 10,00,000 at 10% rate of interest. What are the operating, financial and
ombined leverages ? If the firm wants to double its Earnings before Interest and Tax (EBIT), how
much of a rise in sales would be needed on a percentage basis ?

SOLUTION:
Statement of Profit

Sales 20,00,000
Less: Variable cost 14.00.000
Contribution 6,00,000
Less: Fixed cost 4.00.000
Operating Profit (EBIT) 2,00,00
Less: Interest at 10% on 10,00,000 1.00.000
Profit Before Tax (PBT) 100.000

Calculation of Leverages

(a) Operating Leverage Contribution

Operating Profit (EBIT)

Or, O.L. 6,00,0003.

2,00,000
Earings Before Interest and Tax
(b) Financial Leverage
Profit Before Tax

Or, F.L. 2,00,000

1,00,000
2
c) Combined Leverage = Operating Leverage x Financial Leverage Or, C.L.=3x2 =6

Rise in Sales Needed to Double its EBIT

As the operating leverage is 3, when sales increase by 100% operating profit will increase e
300%. Thus, 33/,% rise in sales volume will increase the operating profit by 100%, ie. doubie

earnings before interest and tax.

Verification
26,66,667
Sales (after 33/,% increase)
18.66.662
Less Variable cost 8,00,000
Contribution 4.00.000
Less: Fixed cost 400.000

Operating Profit or EBIT

Leverages
7.15

IuUSTRATION 12. From the following information, calculate the percentage of change in
are increased by 5%:
earnings per share if sales
lakhs)
Earning before interest and tax (EBIT) 1,120
Profit before tax (PBT) 320
Fixed cost 700

SOLUTION

Operating Leverage Contribution

Earnings before interest and tax
Contribution = Earnings before interest and tax + Fixed Cost
= 1120+ 700 1820

EBIT = 1120 (given)

1820
= 1.625
Operating Leverage 1120

Financial Leverage Earnings before interest and tax

Profit before tax
1120
3.50
320

Combined Leverage Percentage Change in EPS

Percentage Change in Sales
Percentage Changein EPS
Operating Leverage Financial Leverage Percentage Change in Sales
1.625 x 3.50
-Percentage Change in EPS
=

5
Percentage Change in EPS = 5 (1.625 x 3.50)
28.437%

LLUSTRATION 13.A company has sales of 10 lakhs. The variable costs are 40% of the sales
while the fixed operating costs amount to 3,00,000. The amont of interest on long-term debt is
1,00,000.
You are required to calculate the Operating, Financial and Composit Leverages and illustrate its
impact if sales increased by 5%.
SOLUTION:
Statement of Profit

Sales 10,00,000
Less: Variable cost (40% ofSales) 400.000
Contribution 6,00,000
Less: Fixed 3.00.000
Operating Costs 3,00,000
Operating Profit (EBIT)
Less: Interest on Long-term Debt 1.00.000
Earning before Tax (EBT or PBT) 2.00.000
 7.16

Calculation of Leverages Leverages

(i) Operating Leverage Contribution
EBIT

Or O.L. = 6,00,000 2
3,00,000
EBIT
(ii) Financial Leverage
EBT

Or FL. = 3,00,000 :1.5

2,00,000
(ii) Composite Leverage = Operating Leverage x Financial Leverage
Or C.L. = 2 x 1.5 = 3

Impact of Increase in Sales by 5%

As the composite leverage is 3, it indicates that with
every increase in sales by 1%, the EBT or
profit before tax will increase by 3%. Thus, increase in sales by 5% will increase the EBT or
profit
before tax by (3 x 5%), i.e. 15%.

Verification
Sales (after 5% increase) 10,59,000
Less: Variable Costs (40% of Sales) 4.20.000
Contribution 6,30,000
Less: Fixed Operating Costs 3.00.000
Operating Profit (EBIT) 3,30,000
Less: Interest on Long-term Debt 100.000
Earnings before Tax (EBT or PBT) 2.30.00
The EBT has increased from 2,00,000 to 2,30,000, i.e. 15%
LLUSTRATION 14. Calculate operating leverage and financial leverage under situations 1 and ?
and financial plans A and B respectively from the following information relating to the operation an
capital structure of a company. What are the combinations of operating and financial leverage wh
give highest and least value?
Installed capacity 2,000 units
Annual production and sales 50% of installed capacity
Selling price per unit 20
Variable cost per unit 10
Fixed Costs:
Situation 1: 4,000
Situation 2 5,000
Capital structure:
Financial Plan
A B

( (
Equity 5,000 15,000
Debt (cost 10%) 15.000 5.000
20.000 20,000
 7.17
Leverages

SOLUTION:

Actual Production and sales 50% of 2,000 = 1,000 units

Contribution per unit 10
Total Contribution
1,000 x 10 =7 10,000.

Computation of Leverages
Financial Plan
A B
Situation 1 2 2
( ( ( (
Contribution 10,000 10,000 0,000 10,000
Less: Fixed cost 4,000 5,000 4,000 5,000
Operating Profit (EBIT) 6,000 5,000 6,000 5,000
Less: Interest 10% 1,500 L,500 500 500
Profit Before Tax (PBT) 4,500 3,500 5,500 4,500
Contribution 10,000 10,000 10,000 10,000
(a) Operating Leverage EBIT 5,000
6,000 5,000 6,000
= 1.67 = 2 1.67 2
EBIT 6,000 5,000 6,000 5,000
(b) Financial Leverage= PBT 4,500 3,500 5,500 4,500
1.33 = 1.43 = 1.09 = 1.11

(c) Combined Leverage

= Operating Leverage x Financial Levg. 1.67 x 1.33 2x143 1.67 x 1.09 2x1.11
2.22 2.86 = 1.82 2.22
Highest and Least Value of combined Leverage
Highest Value 2.86 under situation 2, Plan A.
=

Least Value = 1.82 under situation 1, Plan B.

ILLUSTRATION 15. Calculate operating, financial and combined leverages from the following
information:
Total Assets 30,00,000
Total Assets Turnover Sales 2 times
Total Assets
Variable Cost on Sales 60%
Fixed Costs 71,00,000
Capital Structure: 27,00,000
Ist Plan IInd Plan

Equity Share Capital 3,00,000 1,00,000

10% Debentures 1,00,000 3,00,000
4,00,000 4,00,000
SOLUTION
Calculation of Sales:
Total Assets Turnover Sales
(Total Assets)
7.18

Leveranen
2 Sales
3,00,000
Sales 3,00,000x 2 =76,00,000
Statement of Profit
Ist Plan IInd Plan

Sales 6,00,000
Less
6,00.000
Variable Cost (60% on Sales) 3,60,000 3,60,00
Contribution 2,40,000
Less: Fixed Cost 2,40,000
1,00,000 1,00,.000
Operating Profit (EBIT) 140,000 1,40,000
Less: Interest on Debentures (10) 10,000 30,000
Earnings Before Tax (EBT) 1,30,000
1,10.00
Calculation of Leverages
Ist Plan IInd Plan
C 2,40,000
(i)Operating LeverageD 2,40,000
1,40,000 1,40,000
= 1.714 1.714
EBIT 1,40,000 1,40,000
(ii) Financial Leverage
EBT
EBT 1,30,000 1,10,000
1.076 1.272
(iii) Combined Leverage (OLx FL) 1.714 x 1.076 1.714x 1272
= 1.844 2.180
-

ILLUSTRATION 16. From the following, prepare Income Statement of company A, Band C.

CompanyA_ Company B Compay

Financial Leverage 3:1 4:1
Interest 200 300
Operating Leverage 4:1 5:1 3:1
Variable cost as a % age of sales 66/,% 75%
Income-tax Rate 45% 45% 45

sOLUTION:

Calculation of EBIT
-

Company A Company B Company C

EBIT
Financial Leverage EBT
3xEBT 4x EBT 2 xEBT
EBIT
2 (EBIT-ID
EBIT 3 (EBIT I) 4 (EBIT )
2 (EBIT 1000)
3 (EBIT 200) 4 (EBIT 300)
72000
300 400
EBIT (solving the equation)
Leverages
7.19

Calculation of Sales
Company A Company B CompanyyC
Operating Leverage
Contribution
EBIT
EBIT
300 400 72,000
Contribution
4x300 1200 5x400 2000 3x2000 = T 6000
Variable Cost (% of sales)
662/3% 75% 50%
Contribution (% age of sales)
33% 25% 50%
Sales 1200x300
2000x
6,000X0
,000xU0

100
=73,600 = 78,000 =T, 12,0000
Income Statement
Company A Company B Company C

Sales
3,600 8,000 12,000
Less: Variable cost
2,400 6,000 6,000
Contribution 1,200 2,000 6,000
Less: Fixed cost (balancing figure) 900 1,600 4,000
EBIT (Earnings before interest and tax) 300 400 2,000
Les: Interest 200 300 1,000
EBT (Earnings before tax) 100 100 1,000
Less: Tax 45% 45 45 450
EAT (Earnings after tax)
55 55
550

Review Questions
A. SHORT ANSWER TYPE QUESTIONS
1. What is
financial leverage?
2. Write note
a on 'tradingequity'.
on
3. What are the limitations of trading on equity.
4. Write a short note on composite leverage.
5. What is meant by operating
leverage ?
B. ESSAY TYPE QUESTIONS
1. What is meant by financial
leverage ? How does it magnify the revenue available for equity shareholders?
2. Define financial leverage. What are different methods of
measuring financial leverage ? Explain the
limitations of financial leverage.
S. Discuss
the relation between debt financing and financial
leverage.
What is
operating leverage ? How does it help in magnifying revenue of a concern ?
 7.20
5. Distinguish between operating leverage and financial leverage. Do you think that
they ars
Leveranen
capital structure ?
6. Write a detailed critical note on financial leverage and financial decision
What is leverage ? Explain financial and operating leverage in detail alongwith their advanta
disadvantages es and

Exercises
Ex. 1. Caiculate the operating, financial and combined
leverage from the
following information
Interest
Sales 5.000
Variable Cost 30.000
Fixed Costs 25.0
15.000
[Ans. O.L. 2.5, F.L. 2, C.L. =3 =

Ex.2 A firm has sales of 7 10,00,000 variable cost

7,00,000 and fixed cost ? 2,00,000 and debt
=

5,00,000 at 10% rate of interest. o

What are the
operating and financial leverages?
Ex. 3. A firm has sales of 7
20,00,000, variable cost of 14,00,000 fixed costs of 7
O.L 3; FL. [Ans. = =

debentures of 7 10,00,000 in its 4,00.000 and

financial
capital structure obtained 1 0 What percent. are is
leverage, operating leverage and combined leverage?
[Ans. F.L. =2;0.L. 3; CL. =o
Ex.4
=

(a) Find the operating leverage from the following:

Sales
Variable costs 5,00,000
Fixed costs
20,000
(b) Find the financial
leverage from the following data:
Net worth
50,00,00
Debt/Equity 3/1
Interest rate
12%
Operating profit 40,00,00

Ans. O.L. =2.5; F.L. =1315|

Ex. 5. Calculate EPS (earning per share) of
Honey Ltd. and Money Ltd.
(a) 20% before tax rate of return on assets assuming
(b) 10% before tax return on assets based on the
following data
Money Ltd
Honey Ltd. (Lakhs)

(Lakhs)
Assets
100
Debt (12% Debentures)
Equity (Shares of 10each)
100
L e v e r a g e s
1.21
Assume 50% income tax in both cases.
Give vour comments on the Financial Leverage.

[Ans. EPS: Honey Ltd. (a) Re. 1.00; (b) Re. 0.50
EP'S: Money Ltd.(a) 140; (b) Re.0.40.]
The following data are available for X Ltd.
Ex.6.
Selling Price per unit =7 120
Variable Cost per unit =* 70
FixedCost =R2,00,000
What is the operating leverage when X Ltd. produces and sells 6,000 units?
() What is the percentage change that will occur in the EBIT of X Ltd. if output increases
by 5%? [Ans. (i) O.L. =3; (ii) 15%.]

Ex 7. Calculate operating leverage and financial leverage from the following data :
Sales (1,00,000 units) =2,00,000
Variable cost per unit = 0.70

Fixed Cost = 65,0000

[Ans.O.L. = 2; F.L. = 1.30.]
Interest Charges = 15,000
x Corporation has estimated that for a new product its break-even point is, 2000 units, if
Ex.8
the item is sold for 14 per unit. The cost account department has currently identified
variable cost of 7 9 per unit. Calculate the degree of operating leverage for sales volume of
2,500 units and 3,000 units, what do you infer from the degree of operating leverage at the
sales volume of 2,500 units and 3,000 units and their difference, if any? Ans. 5 and 3]

Ex.9. Calculate degree of operating leverage, financial leverage and combined leverage from the
following data
Sales 1,00,000 units @ 72 per unit-2,00,000
Variable cost per unit@ Re. 0.70
Fixed Costs- 1,00,000
Interest charges7 3,668 [Ans. 4.33; 1.14; and 4.94]

Ex.10. A company's capital structure consists of 5,00,000 (shares of ? 100 each) equity capital
and 2,00,000 10% Debentures. The sales increased by 20%% from 50,000 units to 60,000
units the selling price is 7 10 per unit; variable cost amount to 7 6 per unit and fixed
expenses amount to 1,00,000. The rate of income tax is assumed to be 50 per cent.
You are required to calculate
i) The percentage increase in earnings per share.
1) The degree of financial leverage at 50,000 units and 60,000 units
ii) The degree of operating leverage at 50,000 units and 60,000 units.
(Nagaland University, 2017 (X2))
[Ans. i) 50% (ii) 1.25 and 1.17 (ii) 2 and 1.71]
 7.22 Leverages
situations A and B and Financiat
Ex. 11. Calculate financial
Plans I and II
leverage and operating leverage under
respectively from the following information relating to the operation and
and
capital structure of ABC Ltd.
1,000 units
Installed capacity
800 units
Actual Production and sales
20
Selling price per unit 15
Variable cost per unit
T 800
Fixed costs: Situation A
T1,500
Situation B
Capital Structure:
Financial Plan

T5,000 T7,000
Equity 2,000
Debt
5,000
How will various calculations be useful to the Financial Manager of the company?
F.L. 1.19, 1.067, 1.25, 1.087 and O.L.
= 1.25 and 1.60]
[Ans. =

Ltd., consists of an equity share

Ex. 12. The Capital structure of the Progressive Corporation
and 7 10,00,000 of 20 % debentures. Sales
capital ofT 10,00,000 (Shares of 10 par value) the selling price is 10 per unit,
increased by 25% from 2,00,000 units to 2,50,000 units,
variable costs amount to 6 per unit and fixed expenses amount to 2,50,000. Income tax
rate is assumed to be 50%
You are required to calculate the following.
(i) The percentage increase in earnings per share.
(ii) The degree of financial leverage at 2,00,000 units and 2,50,000 units.
Cii) The degree of operating leverage at 2,00,000 units and 2,50,000 units.

[Ans. (i) 57.14%; (ii) 1.57, 1.36; (ii) 1.45, 1.33]

Ex. 13. Balance Sheet of X Ltd. as on 31-3-2011 is as follows
Balance Sheet

Liabilities Assets

60,000 Net Fixeed Assets 150,000

Equity Capital (R 10 per share) 50,000
10% Debentures 80,000 Current Assets
Retained Earnings 20,000
Current Liabilities 40.000
2.00.000
2.00.000
The company's total asses turnover ratio is 3. Its fixed operating costs are 1,00,000 ana 1
variable operating cost ratio is 40%, the income tax rate is 50%.
(i) Calculate for the company all the three types of leverages.
(i) Determine the likely level of EBIT if EPS is5.
Ans. (i) O.L. =1385, F.L. = 1.0317, C.L. = 1.429; (i) EBIT = R 68,0
Leverages 1.23

EY 14. The selected financial data for A, B and C companies for the year ended December 31, 2004
are as follows:

A B
Variable expenses as a percentage of sales 50
66/ 75
Interest expenses 200 300 7 1,000
Degree of operating leverage 5-1 6-1 2-1
Degree of financial leverage 3-1 4-1 2-1
Income-tax rate
0.50 0.50 0.50
Prepare income statements for A, B and C companies.
[Ans. Profit After Tax = 7 50, 50 and 500]
Ex. 15. Calculate operating leverage and financial leverage under situation A, B and C and
financial Plans I, II and III respectively from the following information relating to the
operation and capital structure of XYz Co. Also find out the combinations of operating
and financial leverage which give the highest value and the least value. How are these
calculations useful to financial manager in a company?
Installed capacity 1200 units
Actual Production and Sales 800 units
Selling Price per unit T15
Variable cost per unit 10
Fixed Costs: Situation A 1,000
Situation B 2,000
Situation C T 3,000
Capital Structure
Financial Plan
II III

Equity 5,000 7,500 2,500

Debt 5,000 2,500 7,500
Cost of Debt 12%
Ans. Highest value of combined leverage = 40.00, Least value of combined leverage = 1.476]
Ex.16. If the combined leverage and operating leverage figures of a company are 25 and 1.25
respectively, find the financial leverage and P/V ratio, given that the equity dividend per
shares is 2, interest payable per year is ? 1 lakh, total fixed cost 7 0.5 lakh and sales10
lakhs. [Ans. F.L. = 2;P.V. Ratio = 25%.]
EX. 17. The following financial data have been furnished by A Ltd. and B Ltd. for the year ended
31.3.2019
A Ltd. B Ltd.
Operating leverage 3:1 4:1
Financial leverage 2:1 3:1
Interest charges per annum 12 lakhs 10lakhs
Corporate tax rate 40% 40%
Variable cost as % of sales 60% 50%
Frepare income statements of the two companies.
[Ans. Earnings after tax (EAT) A Ltd. F72 lacs and B Ltd. 3 lacs.]
7.24
Leverages
Ex. 18. The balance sheet of Alpha Numeric Company is given below:
Liabilities Assets
Equity capital (R 10 per share) 90,000 Net fixed assets
10% Long-term debt 1,20,000 Current assets 2,25,000
Retained earnings 30,000
75,000
Current liabilities 60.000
3.00.000
3.00.000
The company's total assets turnover ratio is 3, its fixed operating cost is 7 1,50,000 and it
variable operating cost ratio is 50%. The income tax rate is 50%.
You are required to:
() Calculate the different types of leverages for the company.
(i) Determine the likely level of EBIT if EPS is:
(o) Re.1 ()2 c)Re. 0
[Ans.() O.L. 1.50, F.L. 1.042, C.L. 1.563; (i) R30,000,7 48,000 and 12,00.