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    Leverage Basic Concepts PDF

    Uploaded by

    Amoghavarsha BM

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    © All Rights Reserved
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    LeveRAGE - BAS2C CONCEPTS DR. GURUPRASAD MURTHY Professor, Jamnalal Bajaj Institute of Management Studies and SHRI ABID SHAIKH, MMS (JBIM3), presently in United States Lever is a bar used to lift weignts easily and leverage refers to the mechanical jdvantage gained through the use of levers for lifting weights. The basic ingredi-~ ents of lever mechanism. are the load, energy, fulcrus and the lever itself. It is a well known fact that by altering the position of the fulcrum, which is in effect and alteration of the leverage ratio of load to energy, one can lift higher loads using lesser energy. Tha same logic and analogy can be extended to business activity. In the context of business, leverage can relate to oper- ations (operating leverage) and finance (financial leverage). While operating leverage is defined as the ratio of per- centage change in profit before interest and taxes (F8IT) to percentage change in sales, financial leverage is defined as the ratio of percentage change in profit before tax (P27) to percentage change in PBIT. The said formula necessitates data from two finan- cial statements. However, even with the data for a period operating leverage can be calculated as ‘profit contri- bution divided by PBIT'. Similarly financial leverage can be calculated as 'PBIT divided by PBT. In general leverage refers to the profit opportunity which exists or emerges in business because of the fixed nature of certain inputs viz. ‘fixed costs' (period costs) in the case of operating leverage and interest charges (which is a fixed cost) in the context of financial lever~ age. To Understand as to how leverage comes into play, and its impact on key parameters like PBIT and PDT, as @ result of changes in the salés level and/or alteration in the proportion of debt to equity a numerical illustr- ation is presented. Table ne shows “he revenue-cost profile for five different sales level with each sales representing a constant (100%) percent increase in sales over the previous level. The impact of the said per cent increase in sales on PBIT is highlighted in Table ‘wo. apie -_it apie —_it cases compared, change in sales $= xr with I 100 Ints xin wich ID 400 20 xv with ID 100 133 vwith IV 100 4 ma data vin tenis SS oyesciit: Saty Glee that ‘the breakeven sales pe apeee cis Re> 2) jans. And the Phignlighees in Tabeh wo speaks of the decelerating ek Sot accolerst io et profiva, srtiewing cent increas? jn the sales prodices magnifying: nite, impact on PBIT. Again. com Sarr with ts with Raia ty wie Ve cogastnntias 1008 SRC in eajes,, in each, OS ateons preduces 2 20 say ana 114 peccent & cismnppxt, respectively {vide Table 0). TE e chfurener observed £TaY 2s the altered sale! Se frase tbs peeareyeg Gat, the gap between ay of change in sali aaa. eos) $6088 Richaclackerscoieany =e to change more Mon thal aiceren, See rcent change Pergfold impact on profits, ‘che breakeven Ca ee a ee Polatively moderate eae rate of fevourapie change 1? operating Yrofit. conceptuliasl eeimoac: of She chase Gn sales on, operating profit, erating Leverage oA! be defined ar the product Of ERP percent increase 28 sales and 18 if the invccuse’ in sales equals operating leverage. Thus, cee" (gay Jand_ operating leverage is (cimas say), the Shange in FBIT, follwing the change i sale is ‘a x bY cn fable ‘wo, where the mechanism of operating leverage dith respect. to the Gata in Table One if worked out, ME ts found, for instance, while cooparing case TIE with Sse 2% that a 100 per cent increase in sales, encounters te operating leverage 2£ 2 (times) and causs® favourable Deer ga inbwa tt sop 200, (2%, 10D) x The See modalities Gre applicable to other comparisons shown ip Table ‘Wo. prom the abowe data ve can say that one of the factors Sirectiae reise degree operating. ieverage is. the B2eiAlY pert es eran) asgantviing jets! <0f oeratleay oe the breakev: Jn? gacl.. operating . leverage / wan defined as Profit contribution divided by Profit befor eg a ee ee Ee Mee ey rear eaceorns vine 7 feaealsessene AER Ee ee ce seine peice tow ene Vink beter. numerator and the denominator, given a~ numerator, i# Ree rece. tajoss, am anaivhan che Fixed, come 1nCeer eS. the Fives Geclines, operating leverage increases and £hf Be eaaguityina imqsct noveanta © Pigher level 12 2 eer cai ection stney kveceuvmngly Fined gost, 4H) Meese upward ie unlesa the coftribution increesés part passe contrariwise if the fixed costs are reduced the breakeven coneear ia NMowered and the profit boosting process, starts Be og otis caw toes antes iucat in the MeMnieney direction. Similarly reduction in variable costs will oe ess oiorie rely St pete wae Se Cait te eprofit comencencnt’ (because tae breskeves point is shifted to a lower level). the next alternative open to enterprise {8 Prive reduction. However, ~ price increase /decr eee has to -be cee dn conjunction with competition, conrrols demand Uinsticities end volume considerations. 1 this mus clostdcd the complexities associated with multiple product 3 because of product-mix problems. — powever, @ high operating leverage sis? apacrane aspeces ct, trim DroFLE 40: C700" S of ent tit chanjeazin eaves. being ing-abous, * rather @ 53° ee eciopace, charwe, fn. che cesar> S000 small inczeases Peetca cawan sa maunseiing. Dpdce. oS profits, aad Geel decressea in gales cause & in profits. High operacing leverage, not only reveals high profit Rprortintty- but also: indicates: Spee of enterprise OPPOrTgk of ‘great losaéa’. The cnterprise is therefore Vulnerable to a high degree of risk-supernormal profits or abnormal losses- pinancial Leverage Gimnaeiei (leverage cater toatne: prot advant reaped by business through the use of debt in the cap: Aernccure, and is defined =as (part/PaT) and expressed See eigen eatinls sie wecmniaes oF financial leversge ae tmilar to operating. leverage A given Per cent increase io "ies, experimces_a profit boostiss effect equal tg the product of the percent change it, pBIT and fananc ial Terseeyeradorif cuere. teen: sncreese—t operating profit of ‘ct (say) and financial leve ‘3 iat (times-say) Peep anarae ein proric ToMoMiNs tn in BIT, is tee car) percent. A comparison of profits wder different pir levels is presented in Table Three below. 111 with ID avwith III vwith IV ety ee ee ET that tor a given 200 per cent change in FAI and a financial leverage of 2 times, the change in PBT 1° (200 x 2) i.e. 400 ee a ee ot eS ee 1 1 represents ‘an increase 2f Rs. 2 lacs over case II i.e. a 10 percent Gncrease over the Rs.0.5 lacs profil: sf case II. the Same logic can be extended to otner cases of comparison presented in Table Three. ‘At and near the breakeven point a given change in the operating profit, produces a massive increase in the profit before tax. And away from the breakeven point ‘the change in operating profit produces but a reduced acceleration in the profit before tax. The said phenomenon can be observed in Table III where the rate of change in profit declarates from 400. percent to 123 percent. Financial leverage arises mainly due to the interest charges or finance costs which is a fixed’ amount (Period costs) intercepting the PBIT and PBT. But this phenomenon cannot be accepted as valid for all capital structures ‘and without meet ., the underlying prerequisites. A change in the capital structure that is to say the finance mix (proportions of debt to equity), will alter the finangial leverage effects.* Further, regardless of the proportion between debt: equity, the benefits of finanéial leverage will accrue if and only if the productivity or earning power of assets is greater than the interest cost of debt. So long as the efficiency of capital exceeds the cost of capital, the benefits of financial leverage will accrue. It is interesting to observe the modalities Of financial leverage with the aid of an illustration. Hence the change in profitability, due to altered parities between the efficiency and cost of capital for a given leverage in capital structure, and the consequential impact on the return on aquity for three different debt: equity ratios, ere presented in Tables Four, Five and Six, pl Financial leverage is also defined as the ratio of borrowed capital to the ownership capital. the following points are worth noting *~ TABLE w pQuity = Rs. 60 pebt = RS. NIL pep: egorry nario ( 0: 1 weg cn Soares PINANCIAL LEVERAGE (Tines) eit 1 port (Rs.) pe ee ee awrerest (Rs-) @ 108 eee gee 0.79 per (Rs.) eos evo Se Tax (RS.) @ 604 Ren Go ee per (Rs.) ge aae a A ae 10 2 6.7 16.7 33-3 ROE (8) eee es maple four presents a zero debt, ful) equity funding Dictation: (As the smcunt of | Fert Yhcreases the return Bn equity also increases. The ‘financial leverage defined MES sven ie unity. theovibot aifferent PBIT Beriite willuatcated..Te Secury °2 equity ranges from Pel paraak st ac rnrretevel of 5 120% to 33.3 percent: aca BBIT level of Rs. 50 lace EQUITY = Rs. 30 DEBT == RS. 30 P Q R s 2 0 FINANCIAL LEVERAGE (Times) - a2 1.42 1.13 1.06 pair (Rs) ° 5 6 10 3. 50 INTEREST (Rs-) ae @ (108) 3 3 3 3 A 3 PaT (Ra.) ao 2 3 7 Bay 247 TAX (Rs.) 608 - 4220-7 19842 213, cee Pat (Rs.) a 0.0. 1.2 28s oe Tee ROE (8) (10) 2? 44 9.3 - 29. dgeeh2e7 table Five assumes a debt: equity ratio of 1:1. ‘he capital structure is now levered. The | PBIT levels considered in Table Four are also presented in Table Five. At a PBIT level of Rs. 5 lacs, the ROE is 2.78 and at a PBIT level of Rs. 6 lacs the ROE is 4%. After the Rs. 6 lacs PBIT level, (the indifference level) the ROE increases to 9.38, 20.3% and 62.78 for PBIT levels of Rs. 10, Rs. 25 and Rs. 50 lacs respectively. The return on equity has increased by 132 percen: (at PBIT level of Rs. 10 lacs), by 215 percent (at PBIT level of Rs. 25 lacs) and 113 percent (at PBIT level of Rs. 50 lacs). ; (Rs. in Lakhs) RQUITY = Rs. 20 DEST = Rs. 40 DEBT orry RATIO (2 2.1) P Q R s T a FINANCIAL LEVERAGE (Times) = 5 3 1.67 1.19 1.08 PEIT (Rs.) ° 5 645-10 es 50 INTEREST (Rs.) @ 108 4 4 4 4 4 4 PBT (Ra.) a 1 gh 6 a 46 TAX (Ra.) @ 608 - Ox «61.2 3-6 12.6 27.6 a4 184 PAT (Rs.) @ 4 ue 92 ROE (6) Table six considers a debt: equity ratio of 2:1, with the PBIT levels assumed in Tables Four and Five. The ROE is 4 percent at PBIT level of Rs. 6 lacs thus, indicating that the said PBIT is the indifference point insensitive to the capital structure. PBIT levels above Rs. 6 lacs, will experierce the positive and favourable boost effects of leverage, Below PBIT of RS. 6 lacs the ROE is lowest ia Table Six, where the leverage is relatively the highest. This signals the possible boomerang effects of leverage in the event of a landslide when the return on assets falls below the interest cost. At a PBIT level of Rs, 6 lacs, which repr: sents a 10 percent return on capital of &3. «0 lacs, the us interest rate’ be..; 10 per cent, +'> ..ecprise would be indifferent to the mix -:.:cn different sources of finance. Thus, ROE is immune to any changes in the capital structure or debt: equity ratio. At PBIT levels above this indifference point, the ROE is an increase function of the leverage and vice-versa for PBIT levels below ks. 6 lacs. Combined leverage 3 Combined leverage refers to the change in profit following the change in sales and is a function of operating and financial leverage. If there is 'a' percent increase in sales and combined leverage is times, the change in profit is ' la! cere-st. in terms of the itens and data Taole une the ccuo-ned leverage is defined te (Contribution Morgin/PBI7). in other words, combined leverage is a physical product of the two different lever- ages discussed earlier namely ‘Cperating Leverage’ and Financial Leverage’. Operating Leverage is (contribuzion margin/PBIt) and Finsacial Leverage is (PBIT/PBT). The product of the two gives 'Combintd Leverage i.e., (Contri- bution Margin/PBT). Now, comparing cases III and II, a given 100 percent increase in sales and a combined leverage of 4 (i 2x2 times), the change in profit would be 100 x 4 i.e. 400 percent. The PBT of case IIT of Rs. 2.5 lacs is in fact a four fold increase over the PST level of Rs. .5 lacs of Case II, A comparison of the impact, of the combined leverage on the PST is presented in Table Seven. Tt should be noted that operating leverage arises trom the intercept of fixed costs between contribution margin and PBIT and financial leverage stems fron interest cost, intercepting PBIT and Por. Thus, combined leverage is the result of the finan- cial leverage super-imposed on operating leverage. The theme is clear. Operating and financial leverage, can have a magnifying impact on PBIT and PBT following even small changes inthe sales level : (rs. in Lakhs) 86 As an extension of the Tables Four, Five and Six, Exhibits A, B, and C present a visual display of the inpact of leverage of ROE. Exhibit A shows the graphical presentation of the impact of alternative PBIT Jevels, given the debt: equity ratio on the X axis, aad the return of Uquity (¥ axis). he ROE is constant, at a PBIT level of Rs. 6 lacs, for varying proportions of debt: equity. Above the indifference PBIT curve of Rs. 6 lacs, the ROE is a function of PBIT for a given debt: equity ratio and leverage for any given PBIT Level. Exhibit B shows PBIT in the X axis and ROE on the ¥ axis and portrays the impact of alternative debt: equity ratios, given the PBIT levels on the ROE., The same :deas enunciated earlier emerge. The three debt: equity retios curves (vis. 0:1, 1:1 and 2:1)‘intersect with each other at a PBIT level of Rs. 6 lacs(X axis) and the correspording ROE, shown on the Y axis is 4 per cent. After the irter- section, the ROE is an increasing function of the

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