Leverage:

The ability to influence a system, or an environment, in a way that

multiplies the outcome of one’s efforts without a corresponding
increase in the consumption of resources. In other words, leverage is
the advantageous condition of having a relatively small amount of
cost yield a relatively high level of returns. See also financial leverage
and operating leverage.

Definition of Leverage:

“Leverage is the use of debt by a company to fund its operations and

expansion projects in an effort to generate a return for shareholders.
Companies that aggressively use debt financing are considered highly
leveraged and typically risky to invest in.”

According to Jemes C. Ven Home, “ Leverage refers to the use of

fixed cost in an attempt to increase (or lever up) profitability.”

According to J.E. Walter, “Leverage may be defined as percentage

return on equity and the net rate of return on total capitalization.”

The Importance of Leverage:

Management roles are defined by the capacity to motivate and

leverage human capital in the organization to achieve efficiency in
operations.

1. While there are different ways to view the concept of gaining

leverage, the underlying principle should be one of synergy.
2. Managers are responsible for planning, organizing, staffing,
directing, monitoring, and motivating employees to create
leverage in an operational system. Leverage primarily revolves
around effective delegation and motivation.

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 3. Effective managers must have a thorough understanding of
each employee’s strengths and weaknesses, as well as their
aspirations and motivators, to appropriately carry out essential
tasks.
4. Through combining delegation and motivation skills, managers
effectively leverage human capital to achieve high levels of
efficiency and employee satisfaction.

Advantages of Leverage:-

1. Powerful access to capital:- Financial leverage multiplies

the power of every dollar you put to work. If used
successfully, leveraged finance can accomplish much
more than you could possibly achieve without the
injection of leverage.
2. Ideal for acquisitions, buyouts:- Because of the additional
cost and risk of bulking up on debt, leveraged finance is
best suited for brief periods where your business has a
specific growth objective, such as conducting an
acquisition, management buyout, share buyback or a one-
time dividend.
Disadvantages of Leverage:
1. Risky from of finance:- Debt is a source of funding that
can help a business grow more quickly. Leverage
finance is even more powerful, but the higher-than-
normal debt level can put a business into a state of
leverage that is too high which magnifies exposure to
risk.

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 2. More costly:- Leveraged finance products, such as
leveraged loans and high yield bonds, pay higher
interest rates to compensate investors for taking to
compensate investors for taking on more risk.
3. Complex:- The financial instruments involved, such as
subordinated mezzanine debt, are more complex. This
complexity calls for additional management time and
involves various risks.

There are three types financial leverage :-

1. Operating leverage .
2. Financial leverage .
3. Combine leverage .

Operating Leverage

Operating leverage refers to the use of fixed operating costs such as

depreciation, insurance of assets, repairs and maintenance, property
taxes etc. in the operations of a firm. But it does not include interest
on debt capital.
Higher the proportion of fixed operating cost as compared to variable
cost, higher is the operating leverage, and vice versa.

Operating leverage occurs when a firm incurs fixed costs which are to
be recovered out of sales revenue irrespective of the volume of
business in a period. In a firm having fixed costs in the total cost
structure, a given change in sales will result in a disproportionate
change in the operating profit or EBIT of the firm.

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If there is no fixed cost in the total cost structure, then the firm will
not have an operating leverage. In that case, the operating profit or
EBIT varies in direct proportion to the changes in sales volume.

Operating leverage is associated with operating risk or business risk.

The higher the fixed operating costs, the higher the firm’s operating
leverage and its operating risk. Operating risk is the degree of
uncertainty that the firm has faced in meeting its fixed operating cost
where there is variability of EBIT.

It arises when there is volatility in earnings of a firm due to changes

in demand, supply, economic environment, business conditions etc.
The larger the magnitude of operating leverage, the larger is the
volume of sales required to cover all fixed costs.

DEFINATION OF OPERATING LEVERAGE

Operating leverage may be defined as the “firm’s ability to use
fixed operating cost to magnify effects of changes in sales on its
earnings before interest and taxes.”
Contribution

Operating leverage = ---------------------

EBIT/ Operating Profit

Contribution = Sales – Variable cost

Operating Profit = Sales – Variable Cost- Fixed cost

O.P. = contribution – Fixed cost

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In practice, a firm will have three types of cost viz :

(i) Variable cost that tends to vary in direct proportion to the

change in the volume of activity,

(ii) Fixed costs which tend to remain fixed irrespective of

variations in the volume of activity within a relevant range and
during a defined period of time,

(iii) Semi-variable or Semi-fixed costs which are partly

fixed and partly variable. They can be segregated into variable
and fixed elements and included in the respective group of
costs.

DEGREE OF OPERATING LEVERAGE:

Operating leverage may also be described in an another way. It can be

expressed as a ratio between the percentage change in EBIT
associated with percentage change in sales revenue. It is a quantitative
measurement of the degree of operating leverage. When the
percentage change in EBIT due to change in sales revenue exceeds
the percentage change in sales revenue, operating leverage is said to
operate. In the form of formula.

% change in EBIT

Degree of Operating Leverage (DOL) = -----------------------

% Change in Sales

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Example 5.1:
Calculate the operating leverage from the following data:

Sales: 1, 50,000 units at Rs 4 per unit.

Variable cost per unit Rs 2.

Fixed cost Rs 1, 50,000.

Interest charges Rs 25,000.

Solution:
Here,
sales = 1,50,000 ×Rs 4 Rs
6,00,000
Less: variable cost (1,50,000×Rs 2 Rs
3,00,000
Contribution Rs
3,00,000
Less: Fixed cost Rs
1,50,000
EBIT Rs
1,50,000

contribution
Operating Leverage = -----------------------

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 EBIT

= Rs 3,00,000
Rs 1,50,000
=2

Uses of Operating Leverage

i. Operating leverage is one of the techniques to measure the impact
of changes in sales which lead for change in the profits of the
company.
ii. If any change in the sales, it will lead to corresponding changes in
profit.
iii. Operating leverage helps to identify the position of fixed cost and
variable cost.
iv. Operating leverage measures the relationship between the sales
and revenue of the company during a particular period.
v. Operating leverage helps to understand the level of fixed cost
which is invested in the operating expenses of business activities.
vi. Operating leverage describes the over all position of the fixed
operating cost.
2 . Financial leverage :-
Financial Leverage: Leverage activities with
financing activities is called financial leverage. Financial
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leverage represents the relationship between the
company’s earnings before interest and taxes (EBIT) or
operating profit and the earning available to equity
shareholders. Financial leverage is defined as “the
ability of a firm to use fixed financial charges to
magnify the effects of changes in EBIT on the earnings
per share”. It involves the use of funds obtained at a
fixed cost in the hope of increasing the return to the
shareholders. Financial leverage can be calculated with
the help of the following formula:

FL = OP/PBT
Where,
FL = Financial leverage
OP = Operating profit (EBIT)
PBT = Profit before tax.

Degree of Financial Leverage: Degree of financial

leverage may be defined as the percentage change in
taxable profit as a result of percentage change in
earning before interest and tax (EBIT). This can be
calculated by the following formula:  DFL= Percentage
change in taxable Income / Precentage change in EBIT.

Factors affecting financial leverage:

Financial leverage is PBIT/ PBT. Therefore as interest
increases, financial leverage will increase.  Interest, in
turn, being the cost of borrowed funds, will increase
with increase in the proportion of debt used for
financing assets. That is why, the ratio of borrowings to

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assets is also called financial leverage. The higher the
degree of financial leverage of a firm, the greater is the
sensitivity of its profits before tax to changes in PBIT.
The combined leverage factor which is the product of
operating leverage and financial leverage determines
the overall sensitivity of profits before tax to change in
sales. As income taxes are calculated as a percentage
of profit before tax, the net profit will normally be
proportionate to the profit before tax. Therefore,
fluctuations in profit before tax will bring about
corresponding fluctuations in net profits which in turn
will bring about fluctuations in earnings per share (EPS)
as EPS equals net profit divided by the number of
equity shares. Therefore, the combined leverage factor
influences the extent to which net profits and EPS will
fluctuate for a given fluctuation in sales.
It is important to remember that additional benefits will
accrue only when the return on assets is higher than
the cost of borrowings. If however, the cost of
borrowings is higher than the return on assets; the
return on net worth will be even less than the return on
assets.
TYPES OF FINANCIAL LEVERGE :-
A. FAVORABLE FINANCIAL LEVRAGE
B. UNFAVORABLE FINANCIAL LEVRAGE
FAVORABLE EFFECT :- Financial leverage is favorable when
the uses to which debt can be put generate returns greater than
the interest expense associated with the debt. Many companies
use financial leverage rather than acquiring more equity capital,
which could reduce the earnings per share of existing
shareholders. This occurs when EPS increases due to

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the use of debt in capital structure. This is as a
result of the rate of return on the company assets
being more than the cost of capital
    

Unfavorable Effect : Unfavorable financial leverage

occurs when EPS decrease because of the debt in
the capital structures. Financial leverage has an
effect in the tax payable. Bond interest is deducted
before arriving at the net profit in which the tax
rate is based.  other effect of financial leverage is
the fact that it increases the degree of fluctuation
in the rate of return upon common stockholders
investment.

Example of Financial leverage :-

There are two companies first company X and

second company y. So company x had favorable
situation and y had unfavourable situation :-

Company X Ltd ;- (Favorable)

Total funds - Rs. 30,00,000

Interest – 10 %

Tax Rate – Rs. 4,00,000

Face value – Rs. 10

1. Situation :- Debt - Nil .

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 2. Situation :- debt – Rs .10,00,000.
3. Situation :- Rs . 20,00,000.

( EBIT- EPS ANALYSIS)

Particula Situation – Situation - Situation – 3

r 1 2

EBIT 4,00,000 4,00,000 4 ,00,000

INTERES NIL 1,00,000 2,00,000

T

EBT 4,00,000 3,00,000 2,00,000

(earning
before
tax )

TAX 12,00,000 90,000 60,000

(30%)

EAT(ear 2,80,000 210000 140000

ning after
tax )

EPS 280000/300 210000/200 140000/1400

000 =Rs 000 =Rs 00= Rs 1. 40
0.93 1.05

Return On Investment = EBIT / Total Investment x 100

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 = 400,000/30,00,000 x100 =
13.33%

Cost of debt = 10 %

Return on investment > Cost of Debt

13.33 % > 10%

Company Y Ltd :- (unfavorable)

Total Funds :- Rs. 30,00,000.

Interest :- 10 % p.a.

Tax :- 30 %

EBIT :- Rs .20,00,000

Face value :- Rs . 10

1. Situation :- Debt – Nil .

2. Situation :- Debt – Rs 10,00,000
3. Situation :- debt – Rs 20,00,000

( EBIT – EPS ANALSIS )

Particular Situation -1 Situation - 2 Situation –

3

EBIT ( -) 2,00,000 2,00,000 2,00,000

Interest Nil 1,00,000 2,00,000

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 EBT 2,00,000 1,00,000 Nil

Tax (30%) 60000 30000 Nil

EAT 1,40,000 70,000 Nil

EPS 140000/30000 70000/20000 Nil

= Rs 0.47 = Rs 0.35

Return On Investment = EBIT / Total Investment x 100

= 2,00,000/30,00,000 x100 =
6.67%

Cost of debt = 10 %

Return on investment < Cost of Debt

6.67 % < 10%

Uses of Financial Leverage

i. Financial leverage helps to examine the relationship
between EBIT and EPS.
ii. Financial leverage measures the percentage of
change in taxable income to the percentage change in
EBIT.
iii. Financial leverage locates the correct profitable
financial decision regarding capital structure of the
company.

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iv. Financial leverage is one of the important devices
which is used to measure the fixed cost proportion with
the total capital of the company.
v. If the firm acquires fix d cost funds at a higher cost,
then the earnings from those assets, the earning per
share and return on equity capital will decrease.
Difference between Operating Leverage and
Financial Leverage :-
1. Operating Leverage results from the existence of fixed
operating expenses in the firm’s income stream whereas
Financial Leverage results from the presence of fixed financial
charges in the firm’s income stream.

2. Operating Leverage is determined by the relationship

between a firm’s sales revenues and its earnings before
interest and taxes (EBIT). Financial Leverage is determined by
the relationship between a firm’s earnings before interest and
tax and after subtracting the interest component.

3. Operating Leverage = Contribution/EBIT and Financial

Leverage = EBIT/EBT

4. Operational Leverage relates to the Assets side of the

Balance Sheet, whereas Financial Leverage relates to the
Liability side of the Balance Sheet.

5. Operational Leverage affects profit before interest and tax,

whereas Financial Leverage affects profit after interest and tax.

6. Operational Leverage involves operating risk of being

unable to cover fixed operating cost, whereas Financial
Leverage involves financial risk of being unable to cover fixed
financial cost.

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7. Operational Leverage is concerned with investment
decisions, whereas Financial Leverage is concerned with
financing decisions.

8. Operating Leverage is described as a first stage leverage,

whereas Financial Leverage is described as a second stage
leverage.

3 . COMBINE LEVERAGE :-

We have observed that operating leverage affects the

business risk and it is measured in terms of changes in
EBIT due to changes in sales. Similarly, financial
leverage affects financial risk and is measured in terms
of percentage change in EBT or EPS relative to
percentage change in EBIT. Since both the leverages are
closely related in ascertaining the ability of the firm to
cover fixed charges (fixed operating costs in the case of
operating leverage and fixed financial costs in the case of
financial leverage), the mixture of the two would give
combined or total leverage which will clarify the
combined effect of operating and financial leverage. The
formula for calculating combined leverage is:

CL = OL X FL

C EBIT

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 CL = ----------x---------
EBIT EBT

C
CL = --------
EBT
And the degree of combined leverage can be computed:

CDL DOL X DFL

% Change in EBIT % Change in EBT/EPS

DCL = ------------------------ x-------------------------
% Change in Sales % change in EBIT

% Change in EBT or EPS

DCL= -----------------------------
% Change in Sales

Thus, the degree of combined leverage has its utility in

explaining the effect of change in sales revenue on
earning per share. It use and utility are more in the case
of selecting financing plan for new investments. If the
firm is likely to increase business risk by new investment
i.e., operating leverage is increased and there is no
change in financial policy (i.e., capital structure remains
the same as before0 then the financial leverage will not
change. As a result, the combined leverage will be

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pushed up and total risk (notwithstanding financial risk
being unchanged) will also increase. Under such a
situation, the firm has to lower down its financial
leverage so that total risk is maintained at earlier level. In
a reverse situation, financial leverage has to be geared
up.

EFFECT OF COMBINED LEVERAGE :-

We have illustrated the effects of combined leverage

through some examples in the preceding pages. The
extent of risk and uncertainty can be determined on the
basis of combined effects operating and financial
leverages. If operating leverage is 3 and financial leverage
is 4, then combined leverage will be 3X4=12. Thus, the
extent of its being favorable or unfavorable will be 12
times. In such a situation, a definite percentage increase
in sales will cause increase 12 times in EBT. But a
definite percentage decline in sales will equally cause a
fall in EBT 12 times. This signifies that the
credit/goodwill of such company will increase in the
market in good years because the market value of its
equity shares will unexpectedly rise due to maximization
of profit and dividend. On the other hand, the volume of
profit may be too poor in bad years to bear with interest

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burden. As a result its equity shares may be issued only
at discount.

If both the operating leverage and financial leverage

of a company are very low, the total risk will be too
low which may indicate that the company is very
fails to avail of the good opportunities of making
better investments because timely raising the
required funds needed for growth, expansion and
diversification becomes quite difficult for such
company.

If operating leverage is high but its financial lever is

low, one’s favorable nature to some extent will
nullify or negate the unfavorable nature of the other.
The best situation will be one when the operating
leverage of a company is low margin of safety of the
first (operating leverage) may operate the business at
high debt-equity ratio and will be successful to earn
maximum profit.

EBIT-EPS ANALYSIS

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 EBIT-EPS analysis is a popular technique of
examining/testing the effects of leverage analysis.
This analysis basically involves the comparative
study at different levels of earnings before interest
and taxes of various alternative financial plans. An
enterprise makes efforts to raise funds in different
proportions from different sources to finance its
investment proposals. For example, the enterprise (i)
may resort to exclusively equity shares, (ii) may use
exclusively debt capital, (iii) may use exclusively
preference share capital, (iv) may use different
combinations of (i) and (iii) mentioned above and
finally, (iv) may use the different combinations of (i),
(ii) and (iii) mentioned above. Selection of those
combinations of various sources would be profitable
at which earnings per share are maximum, provided
the interest and earnings before tax remain constant
in each situation. Thus, EBIT-EPS analysis attempts
to examine and to evaluate the effects of EBIT at
varying levels on the earning per share under
different alternative financial plans.

EBIT-EPS analyses also helps in designing a

suitable capital structure and in measuring the impact

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 of the use of debt capital. Some basis features of EBIT-
EPS analysis are:

(i) If the assets financed with the use of debt yield a

return greater than the cost of capital, EPS
increases without an increase in owner’s equity.
(ii) Companies with high level of the EBIT can make
profitable use of the high degree of leverage to
increase the EPS/ROE.
(iii) When the rate of return on total assets is less
than the cost of debt, EPS/ROE would fall with
the degree of leverage.
(iv) If the company increases its debt beyond a point,
the EPS will continue to rise but the value of the
shares will fall because of greater exposure of
shareholders to financial risk.
(v) One very important factor on which the variability
of EPS depends is the growth and stability of
sales. EPS fluctuates with the fluctuations in
sales, i.e.

%Change in EPS
DCL=---------------------------------
% change in Sales

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 Thus, the magnitude of the EPS variability with
sales will depend upon DCL = DOL x DFL.

Financial Break-even Point:

That level of EBIT which is equal to fixed financial

charges is known as financial break-even point. In other
words, that amount of earnings before interest and taxes
(EBIT) which is required to cover the interest on debt
capital plus dividends on preference shares, is called as
financial break-even, its computational formula is:

PD

F.B.E.= I + -----------

1-t

Here,

I= Annual Interest burden

PD = Dividend on preference shares

1-t= Tax per rupee deducted from unity

It is to be remembered that above the financial

break-even point, the increase in EPS is always higher
than the ratio of increase in EBIT.

Determination of indifference point:

At this stage a simple question arises can there be a level

of EBIT on which EPS remains the same in spite of

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different financial plans, i.e. varying debt equity mixes? It
is quite certain that a level of EBIT can be found out
which may yield the same EPS for any kind of financial
plan. Such a level of EBIT is known as Break-even level
of EBIT or indifference point. At such level of EBIT, it
becomes meaningless for the financial manager as to
which financial plan or capital structure should be
adopted because EPS happens to be the same in each
case. It should be noted that once the EBIT’s level is
above indifference point, the benefit of leverage starts
accruing in terms of earnings per share. In other words,
if there is a possibility of EBIT being more than
indifference point, the use of fixed interest/dividend
because the earnings per share will increase as a result
of positive effect of financial leverage. On the other hand,
if EBIT is expected to be lower than the indifference
point, the EPS can be increased by using the equity
share capital.

EBIT, it becomes meaningless for the financial manager

as to which financial plan or capital structure should be
adopted because EPS happens to be the same in each
case. It should be noted that once the EBIT’s level is
above indifference point, the benefit of leverage starts
accruing in terms of earnings per share. In other words,

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if there is a possibility of EBIT being more than
indifference point,

the use of fixed interest/dividend because the earnings

per share will increase as a result of positive effect of
financial leverage. On the other hand, if EBIT is expected
to be lower than the indifference point, the EPS can be
increased by using the equity share capital.

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 CONCLUSION

The leverage is such a tool which operates both sides. While on

the one hand, it increases the risk, it also provides opportunity,
on the other hand raising the return on capital employed. Till
sales revenue’s level is high, high leverage succeeds in yielding
more than proportionate profit on owners’ capital. But as soon as
sales revenue falls, it also reduces the profit on owners’ capital in
more than proportionate rate. Thus, favorable leverage provides
gains to shareholders and unfavorable leverage results into losses
to shareholders. Thus, it can be said that for trading on high
leverage, high level of skill and prudence is desired.

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