The McGraw-Hill Companies
502 I
Financial Management
50/000
DFL (PBIT = 50,000) =
= 2.5
50,000,000-30,000
DFL (PBIT = 60,000) =
= 2.0
60,000-30,000
Combined Leverage or Total Leverage
Combined leverage, or total leverage, arises from
the existence of fixed operating costs and interest expenses. Thanks to the existence of these
fixed costs, 1 percent change in revenues leads to more than 1 percent change in profit before
tax (or profit after tax or earnings per share). To illustrate this point, consider the case of Finex
Limited, which currently has revenues of Rs 500,000. (Rs 500 units are sold at Rs 1,000 per
unit). Its variable costs are Rs 500 per unit and its fixed operating costs are Rs 200,000. Its fixed
interest expenses are Rs 30,000 and its tax rate is 50 percent. It has 10,000 shares outstanding.
The financial profile of the company at two levels of sales viz. 500 units (the current level)
and 600 (a level 20 percent higher than the current level) is shown below.
Case A
Case B
600 units
500 units
Revenues
500,000
600,000
Variable operating costs
250,000
300,000
Fixed operating costs
200,000
200,000
Profit before interest and taxes
50,000
100,000
Interest
30,000
30,000
Profit before tax
20,000
70,000
Tax
10,000
35,000
Profit after tax
10,000
35,000
1
3.5
Sales
Earnings per share
In the above example, a 20 percent increase in revenues leads to a 250 percent increase in
earnings per share, thanks to the existence of fixed operating costs and interest expenses. Put
differently, fixed costs magnify the impact of changes in revenues. Note that the magnification of revenues works in the reverse direction as well. For example, in the above case a 20
percent decline in unit sales (from 500 units to 400 units) leads to a 250 percent fall in profit
before tax from Rs 20,000 to - Rs 30,000. You can readily verify this yourself.
The sensitivity of profit before tax (or profit after tax or earnings per share) to changes in
unit sales is referred to as the degree of total (or combined) leverage (DTL). Formally, it is
defined as;
T^rrT
% change in PBT
1J I L =
APBT /PBT
=
% change in Q
A[Q(P -V)-F-I] /PBT
=
A Q /Q
AQ /Q
The McGraw-Hill Companies
Capital Structure Decision
| 503 |
_ AQ(P -V) /PBT _ Q(P-V) _ Contribution
AQ/Q
~
PBT
~
^ ^
PBT
Note that DTL is simply the product of DOT (degree of operating leverage) and DFL (degree of financial leverage).
% change in PBIT
DTL
= DOL x DFL =
% change in sales
Contribution
PBIT
x
PBIT
PBT
Contribution
(20.10)
PBT
To illustrate the calculation of DFL, consider the data for Finex Limited: P = Rs 1,000, P =
Rs 500, F = Rs 200,000, and J = Rs 30,000. DTL, which is a function of the level of output (Q)
at which it is calculated, may be computed for Q = 500 units and Q = 600 units.
DTL (Q = 500)
=
500(1,000 - 500)
500(1,000 - 5,000) - 200,000 - 30,000
250,000
= 12.5
20,000
600 (1,000-500)
DTL (Q = 600)
=
600 (1,000 - 500) - 200,000 - 30,000
300,000
= 4.29
70,000
20.4
=
RATIO ANALYSIS
Traditionally, firms have looked at certain ratios to assess whether they have a satisfactory
capital structure. The commonly used ratios are: interest coverage ratio, cash flow coverage
ratio, debt service coverage ratio, and fixed asset coverage ratio.
Interest Coverage Ratio
The interest coverage ratio (also referred to as the times interest
earned ratio) is simply defined as:
Profit before interest and taxes
Interest on debt
To illustrate, suppose the most recent profit before interest and taxes (PBIT) for Vitrex
Company were Rs.120 million and the interest burden on all debt obligations were Rs.20
million. The interest coverage ratio, therefore, would be Rs.120 million/Rs.20 million = 6.
What does it imply? It means that even if PBIT drops by 83!/3 percent, the earnings of Vitrex
Company will cover its interest payment.