Leverage

Business Risks & Financial Risks

Paper 2: Financial Management

Unit 3 of Chapter 4

1
Navin Khandelwal FCA, DISA
Synopsis
 Concept of Leverages.
 Definition.
 Types of leverages.
 Operating  Leverage.   

Prepared By :   CA Naveen 
Khandelwal
 Importance of Operating Leverage.
 Financial leverage.
 Importance of Financial Leverage.
 Combined Leverage
 Graded Illustrations from past CA Exams

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An Intro.

Leverage

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Concept of Leverage
Leverage refers to –
Relationship between two inter related variables.

It represents  ‐
The influence of one financial variable over some other  related 

Prepared By :   CA Naveen 
Khandelwal
financial variable.

DEFINITION ;
% change in one variable  divided by the % change in some 
other variable.
= % change in dependent variable
% change in independent variable 4
An Intro.

Leverage Types

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Leverage Types

Types

Operating Financial Combined

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An Intro.

Operating Leverage (OL)

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Definition

The firm’s position or ability to magnify the effect of change in 
sales over the level  of Earnings Before Interest and Tax (EBIT)

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OR 

Employment of an asset with a fixed cost in the hope that 
sufficient revenue will be generated to cover all the Fixed and 
Variable costs.

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Relationship
Measures the relationship between the sales revenue  and 
EBIT.

Prepared By :   CA Naveen 
OL = C / EBIT 

Khandelwal
OL =   %  change in EBIT  
% change in Sales Revenue 
EBIT = Earning before interest and taxes or :
( Contribution ‐ Fixed Costs)

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Greater Business Risk with
Greater Operating Leverage
Higher Operating Leverage leads to more Business  Risk
A Small Sales decline causes a larger Profit decline

As in our example we see 
% inc in Sales is 10% 
% inc in EBIT is 12.5% 
So our OL is 1.25 Now if we assume that our OL is higher Say 4
Then 10% Change in Sales can cause 40%  (4 x 10 )change in EBIT 
i.e. increase & decrease in both ways

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Importance of OL

A firm should always try to avoid operating under high DOL..

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Khandelwal
Under good economic condition a high OL are favorable for the
firm but under bad economic condition a high OL is not
preferred for the firm.

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Illustration 1

Operating Leverage

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Illustration 1(A)‐
Shahrukh Khan Ltd. has the following details related to Sales, Variable 
Cost & Fixed Costs. Calculation of EBIT & OL has been Shown below.
Particular Amount  Amount  Change/ Change in 
(Previous year) (Current year) Difference %

Sales  10,00,000 11,00,000 1,00,000 10%

Variable Cost 5,00,000 5,50,000 50,000 10%

Contribution 5,00,000 5,50,000

Fixed Cost 1,00,000 1,00,000 0 0

EBIT 4,00,000 4,50,000 50,000 12.5% 13

OL =12.5%/10%=1.25
Illustration 1(B)‐
Shahrukh Khan Ltd. has the following details related to Sales, Variable 
Cost & Fixed Costs. Calculation of EBIT & OL has been Shown below.
Particular Amount 
(Previous year)

Sales  10,00,000

Variable Cost 5,00,000
OL =5,00,000/4,00,0
Contribution 5,00,000 00=1.25

Fixed Cost 1,00,000

EBIT 4,00,000
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An Intro.

Financial Leverage (FL)

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FL means...
•Use of funds with a fixed cost in order to increase
EPS (earning per share).

•Use of companies funds in which it pays a limited

return.

•Use of fixed cost funds in such a way to increase the

return on shareholders funds.

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Definition ‐ FL

FL = % change in EPS
% change in EBIT

Prepared By :   CA Naveen 
Khandelwal
The existence of fixed financing charge is instrumental to
bring this magnifying effect and also determines the extent
of this effect.

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Calculation of Financial
Leverage
FL = EBIT / EBT
or
FL = EBIT / EBIT-I-PD/(1-T)
Where : 
FL = Financial leverage
EBIT =Earning before interest and taxes
EBT = Earning before taxes = EBIT – INTEREST 
PD=Preference Dividend
T=Tax Rate
Illustration 2

Financial Leverage

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Illustration 2(A)‐
Salman Khan Ltd. has the following details related to Sales, Variable 
Cost & Fixed Costs. Calculation of EBIT, EPS & FL has been Shown 
below.
Particular Amount  Amount  Change/ Change in 
(Previous year) (Current  Difference %
year)
Sales  10,00,000 11,00,000 1,00,000 10%

Variable Cost 5,00,000 5,50,000 50,000 10%

Fixed Cost 1,00,000 1,00,000 0 0

EBIT 4,00,000 4,50,000 50,000 12.5%

EPS 10 12 2 20%
FL =20%/12.5%=1.6 20
Illustration 2(B)‐
Salman Khan Ltd. has the following details related to Sales, Variable 
Cost & Fixed Costs. Calculation of EBIT, EBT & FL has been Shown 
below.
Particular Amount 
(Previous year)
FL =4,00,000/2,00,00
0=2
Sales  10,00,000

Variable Cost 5,00,000

Fixed Cost 1,00,000

EBIT 4,00,000

Interest 2,00,000
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EBT 2,00,000
Importance of Financial Leverage
• Higher the level of fixed financial charge, greater would be the
FL.

• The changes in EPS would be at a higher rate than the

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Khandelwal
changes in EBIT.
• The advantage arises from the possibility that funds borrowed
at a fixed interest rate can be used for investment
opportunities earning a rate of return higher than the interest
paid.

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An Intro.

Combined Leverage (CL)

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Definition & Formula
• Potential use of fixed costs, both operating and
financial, which magnifies the effect of sales volume
on the earning per share of the firm

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Khandelwal
= % Change inEPS
% Change in sales

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Combined Leverage

• OL explains           the business risk complexion.

• FL explains            the financial risk  of the firm.

• CL explains             the overall risk of the firm.

• Thus ,   CL = OL X FL

CL = Cont / EBT
Illustration 3

Combined Leverage

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Illustration 3‐
Amir Khan Ltd. Has Following OL & FL . We can Calculate the 
Combined Leverage for it as follows

OL= 1.25

FL= 0.5

CL= 1.25 x 0.5 = 0.625

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Past Examination Problems on
Leverages

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Operating, Financial & Combined Leverage

CA PE‐II, Nov 2002

Illustration 4

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Problem Statement
The data relating to two companies are as given below :
Particulars                                                   Company A Company B
Capital                                        6,00,000  3,50,000
Debentures 4,00,000  6,50,000

Prepared By :   CA Naveen 
Khandelwal
Output (Units) Per Annum 60,000 15,000
Selling Price/ Unit 30 250
Fixed Cost Per Annum 7,00,000  14,00,000
Variable Cost / Unit 10  75
You are required to calculate the Operating leverage , Financial 
Leverage , Combined Leverage of two Companies. 
(Ans ;DOL 2.4,2.14 , DFL 1.11 , 1.07 , DCL 2.66 , 2.29 )
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Operating, Financial & Combined Leverage

CA (Nov – 2004)

Illustration 5

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Problem Statement
The following summarizes the % changes in operating income,
% changes in revenues for pharmaceutical firms.
Change in Revenue Change in Operating Inc
PQR Ltd 27% 25%

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RST Ltd 25% 32%
TUV Ltd 23% 36%
WXY Ltd 21% 40%
Required :
Calculate the degree of Operating Leverage for each of these firms.
Comment also.

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Operating, Financial & Combined Leverage

CA (May – 2008)

Illustration 6

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Problem Statement
The following data relate to RT Ltd :
Rs
Earning before interest and tax (EBIT)                            10,00,000
Fixed cost                                                                             20,00,000

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Earning Before Tax(EBT)                                                       8,00,000
Required :
Calculate Combined Leverage.

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Operating, Financial & Combined Leverage

CA (Nov – 2009)

Illustration 7

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Problem Statement
From the following Financial data of Company A and Company 
B. Prepare their Income Statements.
Company A                 Company B
Variable cost                   56,000                       60% of sales

Prepared By :   CA Naveen 
Khandelwal
Fixed cost                        20,000                            ‐
Interest expenses          12,000                        9,000
Financial Leverage          5:1                                ‐
Operating  Leverage          ‐ 4:1
Income tax rate                30%                           30%
Sales                                    ‐ 1,05,000
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(Ans : EAT A – 2100, B‐ 1050)
Operating, Financial & Combined Leverage

CA (Nov – 2008)

Illustration 7

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Problem Statement
A Company operates at a production level of 1,000 units. The
contribution is Rs 60 per unit, operating leverage is 6, combined
leverage is 24. If tax rate is 30% , what would be its earnings
after tax ?

Prepared By :   CA Naveen 
Khandelwal
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(Ans : Rs 1750)
Operating, Financial & Combined Leverage

CA (Nov – 2007)

Illustration 8

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Problem Statement
Answer the following :
A firm has Sales of Rs 40 lakhs ; Variable cost of Rs 25 lakhs ;
Fixed cost of Rs 6 lakhs ; 10% debts of Rs 30 lakh ; and Equity
Capital of Rs 45 lakhs.

Prepared By :   CA Naveen 
Khandelwal
Required :
Calculate operating and financial leverage.

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(Ans : OL 1.67, FL 1.50)
 Thank You

Prepared By :   CA Naveen 
Khandelwal
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