Analysis of operating and Click to edit Master subtitle style financial leverages

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MEANING
The term leverage refers to means

of accomplishing power for gaining an advantage. 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 word leverage is the employment of fixed assets or funds for which a firm has to meet fixed costs or fixed rate of interest obligation irrespective of the level of 3/8/13

OPERATING LEVERAGE
Operating leverage is concerned with

the operation of any firm.The cost structure of any firm gives rise to operating leverage because of the existence of fixed nature of costs. This leverage relates to the sale and profit varaiation. Operating Leverage = Contribution
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DEGREE OF OPERATING LEVERAGE

Percentage change in EBIT % EBIT

= ________________________ OR ________ % Percentage change in sales Q

The degree of operating leverage can also be expressed as follows: Q (P V) DOL = _________
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product and their cost sheets are given below:

_____________________________ ___________________________

Units Manufactured and sold Firm Y(20,000)

Firm X (20,000 )

Direct Material Direct Labour

10 5

10 5 3/8/13

Solution:
Particulars Firm X Contribution for 2,00,000 20,000 Units Less:Fixed overheads1,00,000 EBIT Operating Leverage (Contribution or EBIT) 1,00,000 2,00,000/1, 00,000) =2 Firm Y 2,00,000 1,50,000 50,000 2,00,000/50,0 00 =4

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Analysis firm Ys operating

Leverage is twice of firm X , as the fixed overheads are higher. The higher the operating leverage ratio the situation is more risky. while a low ratio indicates a larger absorption capacity of a firm in times of adversity.

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Disadvantages
The study of operating leverage

suffers from the following shortfalls:

leverage rests to a large extent on the correctness of the fixed costs identified with a product. Faulty apportionment would distort the usefulness of the ratio.
(ii) the published accounts does not

give details of the fixed cost incurred 3/8/13

FINANCIAL LEVERAGE
The ratio indicates the effects on

earnings by rise of fixed cost funds. It refers to the use of debt in the capital structure. Financial leverage arises when a firm deploys debt funds with fixed charge. The ratio is expressed as follows:
Financial Leverage = EBIT / EBT The higher the ratio, the lower the

cushion for paying interest 3/8/13 on

DEGREE OF FINANCIAL LEVERAGE

% change in EPS ____________________ % change in EBIT or % % EPS EBIT OR

________

EPS can be ascertained as below: EPS =

(EBIT I )(I t) Dp ___________________ N

The degree of financial leverage measures the responsivess of EPS to change in EBIT. Degree of financial leverage can also be expressed as follows: DFL = EBIT ______
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Where, DFL = Degree of financial

leverage
EBIT = Earnings before Interest and

Tax
I = Interest on long term debt t= Corporate income tax rate Dp = Preference Dividend

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Illustration :6.2
The following information is available

for Crompton Ltd., for the year ended 31st March 2009. Interest on debt Corporate tax rate Rs. 4,00,000 40% Preference dividend Rs.2,00,000 Calculate the degree of financial leverage (i) If EBIT is Rs.10,00,000 and3/8/13 if (ii)

Solution:
(i) DFL if EBIT is Rs. 10,00,000

10,00,000 = _________________________________ 0,00,000 4,00,000 [2,00,000/1 0.40] = 3.75 (ii) DFL if EBIT is RS.15,00,000 15,00,000 = ___________________________3/8/13

Total Leverage
Total leverage may be defined as the potential use of fixed costs, both operating and financial , which magnifies the effect of sales volume change on the EPS of the firm. The total leverage is also called as combined leverage. The methods of production employed which are reflected in the asset structure of the firm , influence its operating leverage. For example, substituting machinery 3/8/13

For example, substituting debt for common stock holders equity increases financial leverage. Degree of total leverage can be calculated as follows: DTL = Operating Leverage x Financial Leverage
or =

Contribution

x EBIT

________________ EBIT

_____
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Substituting the value of EPS, we get: DTL = Q (P V) _____________________ Q(P V) F I DP ____ 1t Where, Q = Quantity produced and sold P = Selling price per unit I = Interest cost on debt t = Income- tax rate V = Variable cost per unit F = Fixed operating cost Dp = Preference dividend DTL measures the sensitivity of EPS to change in quantity produced and sold. 3/8/13

Illustration 6.4
Consider the following information for Watson Ltd. Selling price per unit Rs. 200 Variable cost per unit Rs. 120 Fixed cost Interest on debt 12,00,000 Rs.20,00,000 Rs.
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Solution
DTL = 1,20,000 (200 120)
[ 1,20,000 ( 200 120)] 20,00,000 12,00,000 8,00,000

( 1 0.40)

= 96,00,000
96,00,000 96,00,000 20,00,000 12,00,000 13,33,333 =

5 0,66,667

= 1.89

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Operating Financial Effect/Conclusion Leverage Leverage

High

Very risky, High

Illustration :6.2
The following information is available

for Crompton Ltd., for the year ended 31st March 2009. Interest on debt Corporate tax rate Rs. 4,00,000 40% Preference dividend Rs.2,00,000 Calculate the degree of financial leverage (i) If EBIT is Rs.10,00,000 and3/8/13 if (ii)

Solution:
(i) DFL if EBIT is Rs. 10,00,000

10,00,000 = _________________________________ 0,00,000 4,00,000 [2,00,000/1 0.40] = 3.75 (ii) DFL if EBIT is RS.15,00,000
3/8/13 15,00,000