LEVERAGE

PARVESH AGHI

Meaning

The dictionary meaning of the term leverage refers to an increase means of accomplishing purpose. In machines leverages means the instrument that helps us in lifting heavy objects, which may not be otherwise possible. This concept is valid in business too. In Financial management ,it is used to describe the firms ability to use fixed assets costs to satisfy to magnify the returns of its owners

Definition

Leverage is the ratio of the net rate of return on the shareholders equity and net rate of return on total capiatlisation

Type of Leverage
There are three types of leverages 1. Financial leverage 2. Operating leverage 3. Composite leverage

Financial leverage

A firm needs funds to run and manage its activities. The funds are first needed to set a business and then to implement an expansion , diversification and other plans. A decision has to be made regarding the compositions of funds. The funds may be raised through two sources, owners , called owners equity and outsiders , called debt equity

Financial leverage exists whenever a firms has debts as sources of funds that carry a fixed charges

Computation of financial leverage

Where capital structure consists of equity shares and debts. Financial leverage= EBIT EBT = EBIT EBIT-INT

When capital structure consists of equity shares , preference shares and debt FL= EBIT EBIT-INT-(PDX1/1-t)

Degree of Financial leverage DFL

DFL =

% change of EPS % change in EBIT

Operational Leverage
This leverage is associated with employment of fixed costs assets, it is calculated to know income of the company on different levels of sales. It is a measure of effect on operating profit of the concern on change in sales

Operational Leverage

OL=

Contribution EBIT

Contribution= Sales variable cost EBIT = Contribution- fixed cost

Degree of operating leverage

DOL=

%Change in EBIT % Change in Sales

Composite Leverage
Composite leverage is calculated to determine the combined effect of operating and financial leverage CL= Financial Lev X Operating lev

CL= EBIT X Contribution EBT EBIT = Contribution EBT

Degree of Composite leverage

DCL=

% Change in EBT % Change in Sales

Example
Calculate financial , operational and composite leverage from following data Sales 1,00,000 units @2/- Per unit Variable Cost per unit @.70 per unit Fixed Cost Rs 1,00,000 Interest charges on debt Rs 3668

Sales

1,00,000

2 .7

2,00,000 70,000

Variable cost 1,00,000

Contribution

1,30,000

Fixed Cost EBIT Interest EBT Financial lev EBIT/EBT 30000/26632

1,00,000 30,000 3368 26,632 1.126

Operational lev Composite

C/EBIT

1,30,000/30000

4.33

C/ EBT

1,30,000/26632

4.88

DFL DOL DCL %C in EBT/ %Cin Sales

FL= EBIT/EBT OP=C/EBIT CL= C/EBT