LEVERAGE
Concept of Leverage
Leverage indicates the tool which can lift heavy weight
by using a little force. Leverage in financial terms
means any financial technique which can serve this
purpose. It shows the magnification of force. That is
why it is also termed as Gearing.
Leverage is the employment of an asset or fund for
which the firm pays a fixed cost or fixed return.
Significance
The term leverage refers to a relationship between
two interrelated variables.
In financial analysis, the leverage reflects the
responsiveness or influence of one financial
variable over some other financial variable.
It quantifies the relative changes in profit due to
change in the sales. It depicts the change in fixed
costs incurred to sell the goods.
Contd.
It helps the management in controlling operating
costs or varying the profit with an element of risk.
It also helps in forecasting.
It helps in understanding the relationship between
any two variables.
However, the two variables for which the relationship
is to be established should be interrelated, otherwise,
the leverage study may not have any useful purpose
to serve.
Contd.
The two variables when varied show the relative changes.
This variation is called “Degree of Leverage.”
% Change in dependent variable
Degree of Leverage =
% Change in independent variable
Master Table to Calculate the
Leverage
Sales
Less: Variable Cost
Contribution
Less: Fixed Cost
Operating Profit or EBIT
Less: Interest
Earning before Tax (EBT)
Less: Tax
Earning after Tax
Less: Preference Dividend
Earning Available to Equity Shareholder
Contd.
Sales Revenues
Leverages
EBIT
- Variable Cost
- Interest
Contribution
Profit Before Tax
-Fixed Cost
- Tax
EBIT
Profit After Tax
Types of Leverages:
Operating Leverage
Financial Leverage
Combined Leverage
Contd.
The relationship between sales revenue & EBIT
is defined as Operating Leverage & relationship
between EBIT & EPS is defined as Financial
Leverage.
Contd.
The increase in the EBIT indicates fast recovery
of fixed cost from sales revenues.
Lesser the fixed cost, more will be the EBIT and
operating leverage.
Contd.
Increase in the Earning per Share (EPS) refers
value addition in the shareholder’s wealth & viceversa.
So, more the financial leverage more will be
EPS.
Operating Leverage
The operating leverage shows the relationship
between EBIT & Sales revenues.
Contribution
Operating Leverage =
EBIT
Contd.
The degree of operating leverage (DOL) can be
expressed as follows.
% Change in EBIT
DOL =
% Change in Sales Revenue
Financial Leverage
The use of fixed charge sources of funds along with
owner’s equity is described as financial leverage.
It focuses on earn more return on fixed charges funds
(debt) than their costs.
High rate of financial leverage shows fast growth in
EPS in the growing profit era. But in the declining profit
phase it also shows fast decrease in the EPS.
Contd.
So, in short, we can say the leverage shows the
pace of profit or loss.
It also shows relationship of fixed (Interest) &
variable (Dividend) compensation paid or
payable on debt & equity fund respectively.
Contd.
EBIT
Financial Leverage =
`
EBT = EBIT – I
I= Interest
EBT
Contd.
The degree of Financial Leverage can be
expressed as follows.
% Change in EPS
DFL =
% Change in EBIT
Combined Leverage:
Combined leverage is combination of both the leverages.
Combined Leverage = Operating Leverage X Financial Leverage
or
EBIT
Contribution
Combined Leverage =
X
EBT
EBIT
or
Contribution
Combined Leverage =
EBT
Difference between Operating &
Financial Leverage
Operating Leverage
Financial Leverage
Operating Leverage is related to the Financial leverage is more concerned
investment activities (capital expenditure with financial matters. (Capital structure
decision)
or Debt & equity mix)
The Fluctuation in the EBIT can be The change of EPS due to Debt equity
predicted with the help of operating mix is predicted by financial leverage.
leverage.
Financial Manager Uses the operating The use of financial leverage is to make
leverage to identify the items of assets decision in the liability side of the
side of Balance Sheet.
Balance sheet.
Operating leverage is used to predict Financial leverage is used to analyses
Business risk.
the financial risk.