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* Leverages *

Leverage helps both the investor and the firm to invest or operate. However, it comes
with greater risk. If an investor uses leverage to make an investment and the investment moves
against the investor, his or her loss is much greater than it would've been if the investment had
not been leveraged - leverage magnifies both gains and losses. In the business world, a company
can use leverage to try to generate shareholder wealth, but it fails to do so, the interest expense
and credit risk of default destroys shareholder value. However, it also refers to the use of fixed
cost and its attempt to increase the profitability. In this chapter we understand the principles of
operating, financial and combined leverage. Operating Leverage is basically due to fixed cost
associated with the production of goods and services, financial leverage is occurred due to fixed
financial cost that is interest or PBT and combined leverage is combination of both the above
leverage. All these leverage basically affect the level of variability of the firms after tax earning
and helps us to understand the firms overall risk and returns.

Degree of Operating Leverage


Degree of Operating leverage occurs where the fixed cost must be met regardless of
volume or value of sales. Operating leverage results when changes in value of sales produce
wide fluctuations in the operating profits of the firm. Where the change in operating profits after
charging fixed cost is greater than the percentage change in sales the occurrence is known as
operating leverage. The degree of operating leverage can be measured on the basis of fixed cost
in the cost structure. Operating leverage can be determined by means of break-even analysis or
cost-volume profit analysis at any level of sales. In a layman's language, leverage means ratio.
Operating leverage here means ratio of contribution and operating profits in a business concern.
Degree Operating Leverage = % change in PBIT
% change in Sales

Operating Leverage = Sales – Variable Cost


Contribution- Fixed cost

Operating leverage = Contribution


PBIT
A measurement of the degree to which a firm or project incurs a combination of fixed and
variable costs. A business that has a higher proportion of fixed costs and a lower proportion of
variable costs is said to have used more operating leverage. Those businesses with lower fixed
costs and higher variable costs are said to employ less operating leverage. A business that
makes few sales, with each sale providing a very high gross margin, is said to be highly
leveraged. A business that makes many sales, with each sale contributing a very slight margin,
is said to be less leveraged. As the volume of sales in a business increases, each new sale
contributes less to fixed costs and more to profitability.
The higher the degree of operating leverage, the greater the potential danger from forecasting
risk. That is, if a relatively small error is made in forecasting sales, it can be magnified into large
errors in cash flow projections. The opposite is true for businesses that are less leveraged. A
business that sells millions of products a year, with each contributing slightly to paying for fixed
costs, is not as dependent on each individual sale.

Degrees of Financial Leverage


A leverage ratio summarizing the affect a particular amount of financial leverage has on
a company's earnings per share (EPS). Financial leverage involves using fixed costs to finance
the firm, and will include higher expenses before interest and taxes (PBIT). The higher the
degree of financial leverage, the more volatile EPS will be, all other things remaining the same.
The formula is as follows:

Most likely, the firm under evaluation will be trying to optimize EPS, and this ratio can
be used to help determine the most appropriate level of financial leverage to use to achieve that
goal. Financial leverage is also known as trading on equity. In other words, the effect on

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earnings by the use of fixed cost securities (preference shares and debentures) is called financial
leverage.
It is the ratio of net rate of return on shareholders' equity and the net rate of return on
total capitalization. In the words of J.E. Walter, “Financial leverage may be defined as
percentage return on equity to the percentage return on capitalization.” The degree of financial
leverage may be calculated at any level of operating profit as follows:-
Financial Leverage = PBIT.
PBIT – Interest

Financial Leverage = PBIT


PBT

PBIT = Earning Before Interest and Taxes.

PBT = Profits Before Tax

Financial leverage may be Favorable or Unfavorable from the shareholders' point of view.
Leverage is Favorable if sales and PBIT (Earning before interest and tax) levels are rising
because it tends to maximize the earning-per-share (EPS) and dividend per share (DPS) and also
the market price of shares. On the other hand, if sales and PBIT levels are falling leverage tends
to be Unfavorable because it maximizes the related decline in EPS and DPS and also the market
value of share.

Combined Leverage / Total Leverage :


A leverage ratio that summarizes the combined effect the degree of operating leverage (DOL),
and the degree of financial leverage has on earnings per share (EPS), given a particular change
in sales. This ratio can be used to help determine the most optimal level of financial and
operating leverage to use in any firm. For illustration, the formula is:
Degree of Combined Leverage = % Change in EPS
% Change in Sales

= OL X FL

= Contribution X PBIT
PBIT PBT

Combined Leverage = Contribution


PBIT – Interest or PBT
This ratio can be very useful, as it summarizes the effects of combining both financial
and operating leverage, and what effect this combination, or variations of this combination, has
on the corporation's earnings. Not all corporations use both operating and financial leverage,
but if they do, then this formula can be used. It is worth noting that a firm with a relatively high
level of combined leverage is seen as riskier than a firm with less combined leverage, as the high
leverage means more fixed costs to the firm.

Comparison of Operating Leverage with Financial Leverage

Operating Leverage Financial Leverage


The Operating leverage may be defined The Financial leverage may be
as amplification of gross profit (PBIT) defined as amplification of net profit
because of fixed operating expenses. (PBT or EPS) because of interest (and
preference dividend) payable.
Operating leverage = Contribution Financial Leverage= PBIT
PBIT PBT
Operating Leverage is favorable after Financial Leverage is favorable after
operating breakeven level of sales financial breakeven level of sales
Associated risk is called as Business Associated Risk is called as Financial
Risk Risk

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Not adjustable. Depends on nature of Adjustable. How much to borrow is a
business. choice of management.

Break-even analysis

It is a technique for studying the relationship among fixed costs, variable cost, sales volume and
profits. It occurs when the PBIT is equal to zero, as a result of which the earnings per share is
also effectively zero. In other words, the break- even point is the PBIT level where EPS is the
same for two or more financial plans or alternatives. So it effectively analyses the effect of
financing alternatives on earnings per share.

Thus, the operating break-even point is defined as that level of sales at which PBIT is equal to
zero. It is used to find the sales required to reach a target level of PBIT.

Income Statement format :


Particular Amt (Rs)
Sales xxx
(-) Variable Cost (xxx)
Contribution xxx
(-) Fixed Cost (xxx)
Earning Before Interest & Tax (PBIT) xxx
(-) Interest (xxx)
Earning Before Tax (EPBT) xxx
(-) Tax (xxx)
Earning After Tax (EAT) xxx

Formulas relating to the chapter:


1.Operating Leverage = Contribution
PBIT

2. Financial Leverage = PBIT


PBT
3. Combined Leverage = Contribution
PBT

4. PV Ratio = Contribution
Sales
5. PBT = EAT
(1-tax)

Concept Question:
1. Trading of Equity[May 2005, October 2005, May 2007, November 2007]
2. Operating Leverage [November 2009]
3. Financial Leverage [November 2008]
4. Importance of Operating and Financial Leverage
5. What is the relevance of Operating Leverage and Financial Leverage in taking business
decisions? [May 2003]

6. What do you understand by the term ‘financial break-even point’? [May 2004]

7. Distinguish between Operating Leverage and Financial Leverage. [October 2005]

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Practice Sums:
1. A firm produces 5000 units of product A and B. The selling price per unit is Rs. 30 for A
and Rs. 15 for B and variable cost is Rs. 20 for A and Rs.10 for B. If the PBIT is the Rs.
30,000 for A and Rs. 15,000 for B. Find the Fixed cost and operating leverage.

2. Find Financial leverage if the RM ltd. has taken a loan of amount Rs. 10 lakhs @10%
interest and the tax rate is 25%. PBT is Rs. 75000

3. Find the blank value of the income statement and find the values of combined, operating
and financial leverage. Tax rate is 10% and the PV Ratio is 1:2 and Interest rate is 10%
Particular Amt ( Rs.)
Sales 1,00,000
(-)Variable Cost
Contribution
(-) Fixed Cost 25,000
PBIT
(-)Interest 5000
PBT
(-) Tax
EAT 40500

4. Find out financial leverage from the following data:


Net Worth Rs. 10,00,000
PBT Equity Ratio 1:2
Interest Rate 12%
Operating Profit Rs. 5,00,000

5. The following information is available in respect of a firm A Ltd.


Particular 1988 1989
Sales 25,45,345
(-) Variable Cost (10,23,768)
Contribution 15,21,577
(-)Fixed cost (1,50,000) (1,50,000)
NPBIT 13,71,577
(-) Interest (2,75,000) (2,75,000)
NPBT 10,96,577
(-) Tax (12.5%) (1,37,072.125)
NPAT 9,59,504.875
If the sales increase by 25% each year, PV Ratio is 1:3 and there is no change in fixed
cost and interest amount find the Income statement of next year along with the leverages
of both the year.

6. Unit selling price Rs. 20


Unit Variable cost Rs. 10 , Fixed Cost per annum: NIL , Present activity: 5,000units

Change in activity of sales(+) 50%. Show the impact on operating Profit due to proposed
changes in sales.

7. A firm has sales of Rs. 150 lakhs, variable cost of Rs. 84 lakhs and fixed cost of Rs. 12
lakhs. It has a PBT of Rs. 90 lakhs at 9% and equity of Rs. 110 lakhs. [October 2003]
1. What is the firm’s ROI?
2. Does it have favourable
financial leverage?
3. If the firm belongs to an
industry whose asset turnover is 2, does it have a high or low asset leverage?

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4. What is the operating,
financial and combined leverage of the firm?
5. If the sales drop to Rs. 125
lakhs, what will be the new PBIT?
6. At what level the PBT of the
firm will be equal to zero?

8. From the following information of S Ltd. and G. Ltd. compute Operating Leverage,
Financial Leverage and combined leverage [ May – 2007]
S. Ltd (Rs.) G. Ltd (Rs.)
Equity Share of Rs. 10 Each 10,000 90,000
10% Debentures 90,000 10,000
Total Capital Employed 1,00,000 1,00,000
Sales 2,00,000 1,80,000 2,00,000 1,80,000
Less: Variable Cost 1,00,000 90,000 1,00,000 90,000
Contribution 1,00,000 90,000 1,00,000 90,000
Less: Fixed Cost 50,000 50,000 50,000 50,000
EBIT 50,000 40,000 50,000 40,000
Less: Interest 9,000 9,000 1,000 1,000
EBT 41,000 31,000 49,000 39,000

9. Calculate operating leverage and Financial Leverage under situations A, B and C and
Financial Plans I, II and III respectively from the following information relating to the
operation and capital structure of Rani Ltd. Also find out the combinations of operating
and financial leverages, which gives the highest value and the least value, How are these
calculations useful to finance manager. [November – 2007]
Installed Capacity (No. of Units) 1200
Actual Production and Sales (No. of Units) 800
Selling Price Per Unit (Rs.) 15
Variable Cost Per Unit (Rs.) 10
Fixed Cost – Situation A (Rs.) 1000
Fixed Cost – Situation B (Rs.) 2000
Fixed Cost – Situation C (Rs.) 3000
Financial Plans I II III
Equity (Rs.) 5000 7500 2500
12% Debt (Rs.) 5000 2500 7500

Solution of Practice Sums :

1.

Particular A B
Fixed Cost 20,000 10,000
Operating Leverage 1.67 1.67

1. Financial Leverage = 2.33

2. Combined Leverage : 1.67 ; Operating Leverage : 1.5 ; Financial Leverage : 1.11

3. Financial Leverage = 0.88

4. PV Ratio is 1:3 ; Income Statement of 1989 is as follows;

Sales 6,36,336.25

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(-) Variable Cost (2121120.83)

Contribution 10,60,560.42

(-) Fixed Cost (1,50,000)

EBIT 9,10,560.42

(-) Interest (2,75,000)

EBT 6,35,560.42

(-) Tax (79,445.05)

EAT 5,56,115.36

1988 - Combined Leverage : 1.38 ; Operating Leverage : 1.11 ; Financial Leverage : 1.25

1989 - Combined Leverage : 1.67 ; Operating Leverage : 1.16 ; Financial Leverage : 1.42

5. % Change in Operating Profit = 50%

6. 1. RoI = 27%

2. Since RoI ( 27%) > Rate of Interest (9%) ; Financial Leverage is favourable.

3. Low Asset Leverage

4. Combined Leverage : 1.44 ; Operating Leverage : 1.22 ; Financial Leverage : 1.17

5. PBIT = 43 lacs

6. Sales = 45.68 lacs

7. S - Combined Leverage :2.09 ; Operating Leverage :2.25 ; Financial Leverage : 1.29

G - Combined Leverage :2.30 ; Operating Leverage : 2.25 ; Financial Leverage :1.02

8. Plan I - Combined Leverage : 3.325 ; Operating Leverage : 1.33 ; Financial Leverage : 2.5

Plan II - Combined Leverage : 2.86 ; Operating Leverage : 2 ; Financial Leverage : 1.43

Plan III - Combined Leverage : 40 ; Operating Leverage : 4 ; Financial Leverage : 10

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