7.

Financing Decisions - Leverages

Study Session 7
Business Risk & Financial Risk :
Risk faced by the common shareholders is primarily of two types, namely business risk and financial
risk.
Business Risk:-
It refers to the risk associated with the firm’s operations.
It is the uncertainty about the future operating income (EBIT), i.e. how well can we predict operating
incomes?
Financial Risk:-
It refers to the additional risk placed on the firm’s shareholders as a result of debt use i.e. the
additional risk a shareholder bears when a company uses debt in addition to equity financing.
Debt Versus Equity Financing:
Financing a business through borrowing is cheaper than using equity. This is because:
Lenders require a lower rate of return than ordinary shareholders. Debt financial securities present
a lower risk than shares for the finance providers because they have prior claims on annual income
and liquidation.
A profitable business effectively pays less for debt capital than equity for another reason: the debt
interest can be offset against pre-tax profits before the calculation of the corporate tax, thus
reducing the tax paid.
Issuing and transaction costs associated with raising and servicing debt are generally less than for
ordinary shares.
Meaning and Types of Leverage:
Leverage refers to the ability of a firm in employing long term funds having a fixed cost, to enhance
returns to the owners.
In other words, leverage is the amount of debt that a firm uses to finance its assets.
A firm with a lot of debt in its capital structure is said to be highly levered. A firm with no debt is said
to be unlevered.
There are three commonly used measures of leverage in financial analysis. These are:
i. Operating Leverage
ii. Financial Leverage
iii. Combined Leverage
 7.2
- Leverages

Chart Showing Operating Leverage, Financial Leverage and Combined leverage

Profitability Statement
Sales xxx
Less: Variable Cost (xxx)
Contribution xxx
Less: Fixed Cost (xxx) Operating Leverage
Combined
Operating Profit/ EBIT xxx
Leverage
Less: Interest (xxx) Financial Leverage
Earnings Before Tax (EBT) xxx
Less: Tax (xxx)
Profit After Tax (PAT) xxx
Less: Pref. Dividend (if any) (xxx)
Net Earnings available to equity xxx
shareholders/ PAT
No. Equity shares (N)
Earnings per Share (EPS) = (PAT ÷ N)
i. Operating leverage (OL):
Operating leverage (OL) may be defined as the employment of an asset with a fixed cost in the hope
that sufficient revenue will be generated to cover all the fixed and variable costs.
 Operating leverage is a function of three factors:
a) Amount of fixed cost
b) Variable contribution margin and
c) Volume of sales.

𝑪𝒐𝒏𝒕𝒓𝒊𝒃𝒖𝒕𝒊𝒐𝒏(𝑪)
𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑳𝒆𝒗𝒆𝒓𝒂𝒈𝒆 (𝑶𝑳) =
𝑬𝒂𝒎𝒊𝒏𝒈 𝒃𝒆𝒇𝒐𝒓𝒆 𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒂𝒏𝒅 𝒕𝒂𝒙 (𝑬𝑩𝑰𝑻)

Where,
Contribution (C) = Sales - Variable Cost
EBIT = Sales - Variable Cost- Fixed Cost
Break-even Analysis:
Break-even analysis is a generally used technique to study the Cost Volume Profit analysis. This technique
can be explained in two ways:
i. 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.
ii. This technique is used to determine the possible profit/loss at any given level of production or sales.

𝑭𝒊𝒙𝒆𝒅 𝑪𝒐𝒔𝒕
𝑩𝒓𝒆𝒂𝒌 − 𝒆𝒗𝒆𝒏 𝒑𝒐𝒊𝒏𝒕 𝒊𝒏 𝒖𝒏𝒊𝒕𝒔 =
𝑪𝒐𝒏𝒕𝒓𝒊𝒃𝒖𝒕𝒊𝒐𝒏 𝒑𝒆𝒓 𝒖𝒏𝒊𝒕

The relationship between leverage, break-even point and fixed cost as under:
Leverage Break-even point
1. Firm with leverage 1. Higher Break-even point
2. Firm with no leverage 2. Lower Break-even point
 7.3

Fixed cost Operating leverage

1. High fixed cost 1. High degree of operating leverage
2. Lower fixed cost 2. Lower degree of operating leverage

Degree of operating leverage (DOL):

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

𝑷𝒆𝒓𝒄𝒆𝒏𝒕𝒂𝒈𝒆 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑬𝑩𝑰𝑻

𝑫𝒆𝒈𝒓𝒆𝒆 𝒐𝒇 𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑳𝒆𝒗𝒆𝒓𝒂𝒈𝒆 (𝑫𝑶𝑳) =
𝑷𝒆𝒓𝒄𝒆𝒏𝒕𝒂𝒈𝒆 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑺𝒂𝒍𝒆𝒔
Or,
∆𝑬𝑩𝑰𝑻
𝑬𝑩𝑰𝑻
DOL = ∆𝑺𝒂𝒍𝒆𝒔
𝑺𝒂𝒍𝒆𝒔

Where,
∆ EBIT = Change in EBIT
∆ Sales = Change in Sales
Situation 1: No Fixed Cost
DOL =1
Situation 2: If fixed cost exists:
DOL is more than one, operating leverage exists. More is the DOL higher is operating leverage.
A positive DOL/OL means that the firm is operating at higher level than the breakeven level and both
sales and EBIT moves in the same direction.
In case of negative DOL/OL firm operates at lower than the break-even and EBIT is negative.
Situation 3 : When EBIT is Nil (contribution = fixed cost)
DOL = Undefined
The relationship between operating leverage, fixed cost and EBIT

Analysis and Interpretation of operating leverage

S. No. Situation Result
1 No Fixed Cost No operating leverage
2. Higher Fixed cost Higher Break-even point
3. Higher than Break-even level Positive operating leverage
4. Lower than Break-even level Negative operating leverage
 7.4
- Leverages

ii. Financial Leverage:

Financial leverage (FL) maybe defined as ‘the use of funds with a fixed cost in order to increase
earnings per share.’
Financial leverage involves the use of funds obtained at a fixed cost in the hope of increasing the
return to common stockholders.

𝑬𝒂𝒓𝒏𝒊𝒏𝒈 𝒃𝒆𝒇𝒐𝒓𝒆 𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒕𝒂𝒙 (𝑬𝑩𝑰𝑻)

𝑭𝒊𝒏𝒂𝒏𝒄𝒊𝒂𝒍 𝑳𝒆𝒗𝒆𝒓𝒂𝒈𝒆 (𝑭𝑳) =
𝑬𝒂𝒓𝒏𝒊𝒏𝒈 𝒃𝒆𝒇𝒐𝒓𝒆 𝒕𝒂𝒙 (𝑬𝑩𝑰𝑻)

Where,
EBIT = Sales - (Variable cost + Fixed Cost)
EBT = EBIT - Interest
Degree of Financial Leverage (DFL)
Degree of financial leverage is the ratio of the percentage increase in earnings per share (EPS) to
the percentage increase in earnings before interest and taxes (EBIT).
Financial Leverage (FL) is also defined as “the ability of a firm to use fixed financial charges to
magnify the effect of changes in EBIT on EPS.

𝑫𝒆𝒈𝒓𝒆𝒆 𝒐𝒇 𝑭𝒊𝒏𝒂𝒏𝒄𝒊𝒂𝒍 𝑳𝒆𝒗𝒆𝒓𝒂𝒈𝒆 (𝑫𝑭𝑳)

𝑷𝒆𝒓𝒄𝒆𝒏𝒕𝒂𝒈𝒆 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒆𝒂𝒓𝒏𝒊𝒏𝒈 𝒂𝒔 𝒑𝒆𝒓 𝒔𝒉𝒂𝒓𝒆 (𝑬𝑷𝑺)
=
𝑷𝒆𝒓𝒄𝒆𝒏𝒕𝒂𝒈𝒆 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒆𝒂𝒓𝒏𝒊𝒏𝒈 𝒃𝒆𝒇𝒐𝒓𝒆 𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒂𝒏𝒅 𝒕𝒂𝒙 (𝑬𝑩𝑰𝑻)
Or,
∆𝑬𝑷𝑺
𝑬𝑷𝑺
DFL = ∆𝑬𝑩𝑰𝑻
𝑬𝑩𝑰𝑻

Where,
∆ 𝐸𝑃𝑆 = Change in EPS
∆ 𝐸𝐵𝐼𝑇 = Change in EBIT
Situation 1: No Fixed Interest Cost
DFL =1
Situation 2: If fixed interest cost exists:
DFL is more than one (1), financial leverage exists. More is DFL higher is financial leverage.
A positive DFL/ FL means firm is operating at a level higher than break- even point and EBIT and EPS
moves in the same direction.
Negative DFL/ FL indicates the firm is operating at lower than break- even point and EPS is negative.
Situation 3: When EBT is nil (EBIT = Fixed Interest)
DFL = Undefined
The relationship between financial leverage, fixed cost and EBIT
 7.5

The analysis and interpretation of financial leverage is provided as follows:

Sr. No. Situation Result
1. No Fixed Financial Cost No financial leverage
2. Higher Fixed Financial Cost Higher financial leverage
3. When EBIT is higher than Financial Positive financial leverage
Break-even point
4. When EBIT is lower than Financial Negative financial leverage
Break-even point
iii. 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
=
𝑬𝑩𝑻

Degree of combined leverage (DCL).

Degree of combined leverage (DCL) is the ratio of percentage change in earning per share to the
percentage change in sales.
It indicates the effect the sales changes will have on EPS.

𝑫𝑪𝑳 = 𝑫𝑶𝑳 𝑫𝑭𝑳

%𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑬𝑩𝑰𝑻 % 𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑬𝑷𝑺
=
% 𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑺𝒂𝒍𝒆𝒔 %𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑬𝑩𝑰𝑻
%𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑬𝑷𝑺
=
% 𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑺𝒂𝒍𝒆𝒔

Like operating leverage and financial leverage, combined leverage can also be positive and
negative combined leverage.
Analysis and interpretation of combined leverage.
Sl. No. Situation Result
1 No Fixed Cost and Fixed Financial Fixed Cost No Combined leverage
2. Higher Fixed cost Higher Combined Leverage
 7.6
- Leverages

3. Sales level higher than break-even level Positive combined leverage

4. Sales leverage lower than break-even level Negative Combined leverage
QUESTION No. 5 (SM)
Calculate the operating leverage, financial leverage and combined leverage from the following data
under Situation I and II and Financial Plan A and B:
Installed Capacity 4,000 units
Actual Production and Sales 75% of the Capacity
Selling Price ₹30 Per Unit
Variable Cost ₹15 Per Unit

Fixed Cost:
Under Situation I ₹15,000
Under Situation-II ₹20,000

Capital Structure:
Financial Plan
A B
₹ ₹
Equity 10,000 15,000
Debt (Rate of Interest at 20%) 10,000 5,000
20,000 20,000
ANSWER :
 7.7

QUESTION No. 10 (SM)

The following details of a company for the year ended 31st March, 2021 are given below:
Operating leverage 2:1
Combined leverage 2.5:1
Fixed Cost excluding interest ₹ 3.4 lakhs
Sales ₹ 50 lakhs
8% Debentures of ₹ 100 each ₹ 30.25 lakhs
Equity Share Capital of ₹ 10 each 34 lakhs
Income Tax Rate 30%
 7.8
- Leverages

CALCULATE:
(i) Financial Leverage
(ii) P/V ratio and Earning per Share (EPS)
(iii) If the company belongs to an industry, whose assets turnover is 1.5, does it have a high or low assets
turnover?
(iv) At what level of sales, the Earning before Tax (EBT) of the company will be equal to zero?
ANSWER :
7.9
 7.10
- Leverages

QUESTION No. 11 (JAN-2021)

The information related to XYZ Company Ltd. for the year ended 31st March, 2020 are as follows:
Equity Share Capital of ₹ 100 each ₹ 50 Lakhs
12% Bonds of ₹ 1000 each ₹ 30 Lakhs
Sales ₹ 84 Lakhs
Fixed Cost (Excluding Interest) ₹ 7.5 Lakhs
Financial Leverage 1.39
Profit-Volume Ratio 25%
Market Price per Equity Share ₹ 200
Income Tax Rate Applicable 30%
You are required to compute the following:
(i) Operating Leverage
(ii) Combined Leverage
(iii) Earning per share
(iv) Earning Yield
ANSWER :
7.11
 7.12
- Leverages

QUESTION No. 13
A firm has sales of ₹ 75,00,000 variable cost is 56% and fixed cost is ₹ 6,00,000. It has a debt of
₹ 45,00,000 at 9% and equity of ₹ 55,00,000.
(i) What is the firm’s ROI?
(ii) Does it have favourable financial leverage?
(iii) If the firm belongs to an industry whose capital turnover is 3, does it have a high or low capital
turnover?
(iv) What are the operating, financial and combined leverages of the firm?
(v) If the sales is increased by 10% by what percentage EBIT will increase?
(vi) At what level of sales the EBT of the firm will be equal to zero?
(vii) If EBIT increases by 20%, by what percentage EBT will increase?
ANSWER :
7.13
 7.14
- Leverages

QUESTION No. 15
From the following, prepare Income Statement of Company X and Y
Company X Y
Financial leverage 3:1 4:1
Interest ₹200 ₹300
Operating leverage 4:1 5:1
Variable Cost as a Percentage to Sales 66 % 75%
Income tax Rate 45% 45%
ANSWER :
7.15
 7.16
- Leverages

QUESTION No. 27 (NOV-2019)

The Balance Sheet of Gitashree Ltd. is given below:
Liabilities (₹ )
Shareholders’ fund
Equity share capital of ₹ 10 each ₹ 1,80,000
Retained earnings ₹ 60,000 2,40,000
Non-current liabilities 10% debt 2,40,000
Current liabilities 1,20,000
6,00,000
Assets
Fixed Assets 4,50,000
Current Assets 1,50,000
6,00,000
The company's total asset turnover ratio is 4. Its fixed operating cost is ₹ 2,00,000 and its variable
operating cost ratio is 60%. The income tax rate is 30%.
Calculate:
(i) (a) Degree of Operating leverage.
(b) Degree of Financial leverage.
(c) Degree of Combined leverage.
(ii) Find out EBIT if EPS is (a) ₹ 1 (b) ₹ 2 and (c) ₹ 0
ANSWER :
7.17
 7.18
- Leverages

QUESTION No. 28 (MAY-2020)

The following data is available for Stone Ltd. :
(₹)
Sales 5,00,000
(-) Variable cost @ 40% 2,00,000
Contribution 3,00,000
(-) Fixed cost 2,00,000
EBIT 1,00,000
(-) Interest 25,000
Profit before tax 75,000
Using the concept of leverage, find out
(i) The percentage change in taxable income if EBIT increases by 10%.
(ii) The percentage change in EBIT if sales increases by 10%.
(iii) The percentage change in taxable income if sales increases by 10%.
Also verify the results in each of the above case.
ANSWER :
7.19
7.20
- Leverages
 7.21

QUESTION No. 35 (DEC-2021)

Information of A Ltd. is given below:
Earnings after tax 5% on sales
Income tax rate 50%
Degree of Operating Leverage 4 times
10% Debenture in capital structure ₹ 3 lakhs
Variable costs ₹ 6 lakhs
Required:
(i) From the given data complete following statement:
Sales XXXX
Less: Variable costs ₹ 6,00,000
Contribution XXXX
Less: Fixed costs XXXX
EBIT XXXX
Less: Interest expenses XXXX
EBT XXXX
Less: Income tax XXXX
EAT XXXX
(ii) Calculate Financial Leverage and Combined Leverage.
(iii) Calculate the percentage change in earning per share, if sales increased by 5%.
ANSWER :
7.22
- Leverages
 7.23

QUESTION No. 37 (NOV-2022)

The following information is available for SS Ltd.
Profit volume (PV) ratio 30%
Operating leverage 2.00
Financial leverage 1.50
Loan ₹ 1,25,000
Post-tax interest rate 5.6%
Tax rate 30%
Market Price per share (MPS) ₹ 140
Price Earnings Ratio (PER) 10
You are required to:
(1) Prepare the Profit-Loss statement of SS Ltd. and
(2) Find out the number of equity shares.
ANSWER :
7.24
- Leverages
 7.25

QUESTION No. 38 (MAY-2023)

Following information is given for X Ltd.:
Total contribution (₹) 4,25,000
Operating leverage 3.125
15% Preference shares (₹ 100 each) 1,000
Number of equity shares 2,500
Tax rate 50%
Calculate EPS of X Ltd., if 40% decrease in sales will result EPS to zero.
ANSWER :
7.26
- Leverages