Leverages

Financial Leverage and Operating Leverage

Abhishek Agarwal, Application Id: 60833

ABSTRACT This Assignment explains the concept of Financial And Operating Leverages, as I understand it.

Financial Leverage and Operating Leverage

Leverage is generally defined as the ratio of the percentage change in profits to the percentage change in sales. In other words, leverage is the multiplying effect that fixed costs have on profits when there is any change in sales. As sales increases or decreases, it is only the variable costs that change correspondingly, fixed costs remain constant. Profits therefore increase or decrease at a faster rate than the rate of change in sales. This can be better understood with an example.

A hypothetical income statement for a firm is as follows:

Sales Less: Variable costs

2000 800 ------

Contribution Less: Fixed costs

1200 500 ------

Profits

700 ------

If the sales of this firm are increased by 20%, the income statement will stand revised as follows:

Sales Less: Variable costs

2500 1000 ------

(increase of 25%) (increase of 25%)

Contribution Less: Fixed costs

1500 500 --------

(increase of 25%) (No change)

Profits

1000 ---------

With an increase in sales of 25% from Rs. 2,000 to Rs. 2,500, profits have increased from Rs. 700 to Rs. 1000, an increase of 43%. This is the effect of leverage. If the firm had no fixed costs at all but all its costs were variable, there would have been no leverage and the percentage change in sales would have been the same as the percentage change in profits. It is fixed costs that introduce leverage into the firm and higher the fixed cost, higher is the leverage.

You can think of leverage as shorthand for your business's ability to get funding. Higher equity creates increased leverage and vice-versa. If your business is fully leveraged, it won't be able to borrow money.

Leverage tells us how we can know from our sales that how much EBIT (earnings before interest and taxes) will be. In accounting it is called degree of leverage and is calculated as:

DOL= Contribution Margin/EBIT

For exp: if DOL=2 It means if we increase sale by 5% EBIT will increase by 10%.

A firm with no fixed financing costs has no financial leverage. In such a firm, earnings per share will rise and fall with EBIT by the same percentage. For example, a 15% increase in EBIT will result in a 15% increase in EPS; a 9% decrease in EBIT will result in a 9% decrease in EPS.

A firm with some fixed financing costs does have financial leverage. In such a firm, earnings per share will rise and fall with EBIT by a greater percentage. For example, a 15% increase in EBIT will result in a more-than-15% increase in EPS; a 9% decrease in EBIT will result in a more-than-9% decrease in EPS.

There are two types of Leverages:

A. Financial Leverage B. Operating Leverage

Financial Leverage: Financial leverage is the extent to which debt (liability) is used in the Capital Structure (financing) of the firm. Capital Structure refers to the relationship between assets, debt (liability) and equity. The more debt a firm has relative to equity the greater the financial leverage (these firms have a higher Debt to Asset ratios).

Formula: PBIT Financial Leverage = ---------PBT

Operating Leverage: Operating leverage is a measure of the extent to which, fixed operating costs are being used in an organization. It is greatest (largest) in companies that have a high proportion of fixed operating costs in relation (proportion) to variable operating costs. This type of company is using more fixed assets in the operation of the company. Firms with large amounts of fixed operating costs have high break-even points and high operating leverage. Variable cost in these firms tends to be low and both the contribution(CM) and unit contribution (UC) margin is high.

FormulaContribution Operating leverage = ---------------PBIT

Conclusion:

Both operating and financial leverage result in the magnification of changes to earnings due to the presence of fixed costs in a company's cost structure. The

difference is only the part of the income statement we are looking at. Operating leverage is the magnification on the top half of the income statement - how EBIT changes in response to changes in sales; the relevant fixed cost is the fixed cost of operating the business. Financial leverage is the magnification on the bottom half of the income statement - how earnings per share changes in response to changes in EBIT; the relevant fixed cost is the fixed cost of financing, in particular interest.

Choice over operating leverage depends on the technologies available to a company. Some companies have little control over their operating leverage. For example, airlines which have no substitute for airplanes and their associated support systems can only operate with a large investment in fixed assets that create fixed costs. Other companies have a significant degree of control over their operating leverage. Many manufacturing companies, for example, can choose to produce using automated equipment or piecework labor. By contrast, most firms have total control over their financial leverage through their choice of financing (the exception is small firms that have limited access to financial markets, hence limited financing alternatives). A company can increase its financial leverage by using debt financing and can avoid financial leverage through financing with equity.