Financial and

Operating
Leverage

Capital Structure Defined

The term capital structure is used to
represent the proportionate relationship
between debt and equity.
The various means of financing represent the
financial structure of an enterprise. The lefthand side of the balance sheet (liabilities
plus equity) represents the financial
structure of a company. Traditionally, shortterm borrowings are excluded from the list
of methods of financing the firms capital
expenditure.
Prof. Amit Kanjilal (09845028721)

Questions while Making the Financing

Decision
How should the investment project be financed?
Does the way in which the investment projects are
financed matter?
How does financing affect the shareholders risk, return
and value?
Does there exist an optimum financing mix in terms of the
maximum value to the firms shareholders?
Can the optimum financing mix be determined in practice
for a company?
What factors in practice should a company consider in
designing its financing policy?

Prof. Amit Kanjilal (09845028721)

Less
Less

Less
Less

Sales
Variable / Marginal cost
Contribution
Fixed cost other than interest
Earnings before interest & tax (EBIT)
Interest or Fixed charges
Earnings before tax (EBT)
Tax
Earnings after tax (EAT)
Prof. Amit Kanjilal (09845028721)

Meaning of Financial Leverage

The use of the fixed-charges sources of funds, such as
debt and preference capital along with the owners equity
in the capital structure, is described as financial leverage
or gearing or trading on equity.
The financial leverage employed by a company is intended
to earn more return on the fixed-charge funds than their
costs. The surplus (or deficit) will increase (or decrease)
the return on the owners equity. The rate of return on the
owners equity is levered above or below the rate of
return on total assets.

Prof. Amit Kanjilal (09845028721)

Financial Leverage
Financial Leverage = EBIT / EBT
Degree of Financial Leverage = Percentage change in
EPS by Percentage change in EBIT
This ratio indicates the effects on earnings by rise of
fixed cost funds. It refers to the use of debt in the
capital structure. Financial leverage arises when a
firm deploys debt funds with fixed charge. The
degree of financial leverage measures the
responsiveness of EPS to the changes in EBIT.
Prof. Amit Kanjilal (09845028721)

Measures of Financial Leverage

Debt ratio
Debtequity ratio
Interest coverage
The first two measures of financial leverage can be
expressed either in terms of book values or market values.
These two measures are also known as measures of
capital gearing.
The third measure of financial leverage, commonly known
as coverage ratio. The reciprocal of interest coverage is a
measure of the firms income gearing.

Prof. Amit Kanjilal (09845028721)

Financial Leverage and the

Shareholders Return
The primary motive of a company in using financial
leverage is to magnify the shareholders return under
favourable economic conditions. The role of financial
leverage in magnifying the return of the shareholders is
based on the assumptions that the fixed-charges funds
(such as the loan from financial institutions and banks or
debentures) can be obtained at a cost lower than the
firms rate of return on net assets (RONA or ROI).
EPS, ROE and ROI are the important figures for analysing
the impact of financial leverage.

Prof. Amit Kanjilal (09845028721)

Effect of Leverage on ROE and EPS

Favourable

ROI > i

Unfavourable

ROI < i

Neutral

ROI = i

Prof. Amit Kanjilal (09845028721)

Operating Leverage
Operating Leverage = Contribution / EBIT
When there is a change of 1% in sales, produces
a more than 1% change in EBIT, there is a
presence of operating leverage.

Prof. Amit Kanjilal (09845028721)

Operating Leverage
Operating leverage affects
a firms operating profit
(EBIT).
The degree of operating
leverage (DOL) is defined
as the percentage change
in the earnings before
interest and taxes relative
to a given percentage
change in sales.

% Change in EBIT
% Change in Sales
EBIT/EBIT
DOL
Sales/Sales
DOL

Prof. Amit Kanjilal (09845028721)

Combining Financial and Operating

Leverages
Operating leverage affects a firms operating
profit (EBIT), while financial leverage affects
profit after tax or the earnings per share.
The degrees of operating and financial leverages
is combined to see the effect of total leverage on
EPS associated with a given change in sales.
Combined Leverage = Operating Leverage x Financial Leverage
Prof. Amit Kanjilal (09845028721)

Combining Financial and Operating

Leverages
The degree of combined leverage (DCL) is
given by the following equation:

% Change in EBIT % Change in EPS

% Change in EPS

% Change in Sales % Change in EBIT % Change in Sales

another way of expressing the degree of

combined leverage is as follows:
Q( s v)
Q( s v) F
Q(s v)
DCL

Q ( s v) F Q ( s v ) F INT Q ( s v ) F INT

Prof. Amit Kanjilal (09845028721)

Financial Leverage and the

Shareholders Risk
The variability of EBIT and EPS distinguish between two
types of riskoperating risk and financial risk.
Operating risk can be defined as the variability of EBIT (or
return on total assets). The environmentinternal and
externalin which a firm operates determines the
variability of EBIT
The variability of EBIT has two components:
variability of sales
variability of expenses

The variability of EPS caused by the use of financial

leverage is called financial risk.

Prof. Amit Kanjilal (09845028721)

Example 1:
The following figures relate to two companies:
Particulars
Kabutaru Ltd. Rutabuka Ltd.
Sales
Rs.500
Rs.1000
Variable cost
Rs.200
Rs.300
Fixed cost
Rs.150
Rs.400
Interest
Rs.50
Rs.100
Values given above are in lakhs.

Prof. Amit Kanjilal (09845028721)

 You are required to calculate

(a) operating, financial and combined
leverages of the two companies,
and
(b) comment on the relative position of the
companies in respect of the risk.

Prof. Amit Kanjilal (09845028721)

Operating Leverage:
Kabutaru Ltd.= 2; Rutabuka Ltd.= 2.33
Financial Leverage:
Kabutaru Ltd.= 1.5; Rutabuka Ltd.= 1.5
Combined Leverage:
Kabutaru Ltd.= 3; Rutabuka Ltd.= 3.5

Prof. Amit Kanjilal (09845028721)

 The operating leverage is higher for Rutabuka

Ltd. and therefore it is subject to greater
degree of business risk (operating risk) than
Kabutaru Ltd. The EBIT will tend to vary more
with sales in Rutabuka Ltd.
The financial leverage of both the companies
stand at 1.5 times. It conveys that interest
burden is proportionately same, and also
financial risk is similar for both the companies.
The combined leverage of Rutabuka Ltd. is
higher and its overall risk is more as compared
to Kabutaru Ltd.
Prof. Amit Kanjilal (09845028721)

Example 2:
Consider the following information for ROG Ltd.
EBIT Rs.1,120 lakhs
EBT Rs.320 lakhs
Fixed cost Rs.700 lakhs
Calculate the % change in EPS, if sales increased
by 5%.

Prof. Amit Kanjilal (09845028721)

Contribution = EBIT + Fixed cost = Rs.1,820 lakhs

Operating Leverage = Contribution/EBIT = 1.625
Financial Leverage = EBIT / EBT = 3.5
Combined Leverage = OL x FL = 5.687
Combined Leverage = % change in EPS /
% change in Sales
5.687 = % change in EPS / 5
% change in EPS = 5.687 x 5 = 28.44

Prof. Amit Kanjilal (09845028721)

Example 3:
The following figures are available for Success Ltd. :
Net sales: Rs.15 crores (08-09); Rs.20 crores (09-10)
EBIT as % of net sales: 14% (08-09); 16% (09-10)
Debt @ 15% Rs. 5 crores (08-09); Rs.8 crores (09-10)
11%Preference share capital: Rs.2 crores
The applicable Income-tax rate to be taken at 40%
Number of equity shares outstanding: 8 lakhs
Calculate: DOL, DFL & DCL
Prof. Amit Kanjilal (09845028721)

Net sales
EBIT
Interest
EBT
Tax
EAT
Pref. Div.
EAtoESH
No. of Eq. shares
EPS

08-09
15.00
2.10
0.75
1.35
0.54
0.81
0.22
0.59
0.08
7.375
Prof. Amit Kanjilal (09845028721)

09-10
20.00
3.20
1.20
2.00
0.80
1.20
0.22
0.98
0.08
12.25

% change in net sales = ((20 15) / 15 ) x 100

= 33.33
% change in EBIT = ((3.2 2.1) / 2.1 ) x 100
= 52.38
% change in EPS =(( 12.25- 7.375) / 7.375) x 100
= 66.10
Prof. Amit Kanjilal (09845028721)

DOL = 52.38 / 33.33 = 1.572

DFL = 66.10 / 52.38 = 1.262
DCL = 66.10 / 33.33 = 1.983

Prof. Amit Kanjilal (09845028721)