LEVERAGE

OBJECTIVES
Meaning Types Operating Leverage Degree of Operating Leverage Problems

 Leverage refers to an increased means of accomplishing some purpose. In Financial Management the term leverage refers to The firms ability to use fixed cost assets or funds to increase the return to its owners. James Horne has defined leverage as The employment of an asset or sources of funds for which the firm has to pay a fixed cost or fixed return

Types of Leverages
Types
Operating Financial Composite

Operating Leverage
Fixed cost is treated as fulcrum of a leverage Fixed costs remaining same with changes in the volume of output, the percentage change in operating revenue will be more than the percentage change in sales.
Operating leverage = Contribution EBIT Contribution = Sales Variable Cost Operating profit/EBIT = Sales Variable Cost Fixed Cost (OR) Contribution Fixed Cost Degree of operating leverage = % change in profit % change in sales

Effect of Leverage on the Profit

Fixed cost = Rs.50,000 Variable cost = 70% of sales Sales = Rs.2,00,000 in the previous year Rs.2,25,000 in the current year.

Particulars

Previous year Rs.

2,00,000 1,40,000 60,000 50,000

Current year Rs.

2,50,000 1,75,000 75,000 50,000

% change
25% 25% 25%

Sales Less Variable cost Contribution Less Fixed cost Operating profit

10,000

25,000

150%