CHAPTER – SIX

FINANCIAL AND OPERATING

LEVERAGE

By Honelign E. (Ph.D)
Department of Accounting and Finance,
Bahir Dar University
 Chapter Outline:

 6.1. Introduction to Leverage

 6.2. Financial Leverage

 6.3. Operating Leverage

 6.4. Combined leverages

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 6.1. Introduction to Leverage
 The term leverage refers to an increased means
of accomplishing some purpose.
 In the financial point of view, leverage refers to
furnish the ability to use fixed cost assets or
funds to increase the return to its shareholders.
 Leverage is the employment of an asset or fund
for which the firm pays a fixed cost or fixed
return.

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 The company may use finance or leverage or
operating leverage, to increase the EBIT and
EPS.
 Leverage can be classified into three major
headings according to the nature of the finance
mix of the company.
 These are
 Operating Leverage,
 Financial Leverage, and
 Composite Leverage
 Leverage measures the capital structure of an
enterprise.
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 What is Capital Structure ?
 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 left-hand side of the balance sheet (liabilities
plus equity) represents the financial structure of a
company.
 Traditionally, short-term borrowings are excluded
from the list of methods of financing the firm’s
capital expenditure.
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 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 firm’s
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?

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 6.2. 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.
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 Measures of Financial Leverage
 Debt ratio
 Debt–equity 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 firm’s income gearing.
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 Financial leverage may be favourable or
unfavourable depends upon the use of fixed cost
funds.
 Favourable financial leverage occurs when the
company earns more on the assets purchased with
the funds, then the fixed cost of their use.
 Hence, it is also called as positive financial
leverage.
 Unfavourable financial leverage occurs when the
company does not earn as much as the funds cost.
 Hence, it is also called as negative financial
leverage.

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 Financial leverage can be calculated with the help
of the following formula:
Financial leverage = Operating profit (EBIT)
Profit before tax
 Degree of financial leverage (DFL) may be defined
as the percentage change in taxable profit as a
result of percentage change in earnings before
interest and tax (EBIT).
 This can be calculated by the following formula:
DFL = Percentage change in taxable Income
Percentage change in EBIT
 Financial leverage helps to examine the
relationship between EBIT and EPS.
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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 firm’s rate of return on net assets (RONA or
ROI).
 EPS, ROE and ROI are the important figures for
analysing the impact of financial leverage.

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 Financial leverage measures the percentage of
change in taxable income to the percentage
change in EBIT.
 Financial leverage locates the correct profitable
financial decision regarding capital structure of the
company.
 If the firm acquires fixed cost funds at a higher
cost, then the earnings from those assets, the
earning per share and return on equity capital will
decrease.
 The impact of financial leverage can be understood
with the help of the following exercise.

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 Example:
 Minilik II Plc. decides to use two financial plans and
they need Br. 50,000 for total investment.
Particulars Plan A Plan B
Debenture (interest at 10%) 40,000 10,000
Equity share (Br. 10 each) 10,000 40,000
Total investment needed 50,000 50,000
Number of equity shares 4,000 1,000
 The earnings before interest and tax are assumed
at Br. 5,000, and 12,500. The tax rate is 30%.
Calculate the EPS.
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 Solution: EPS when EBIT is Br. 5,000
Particulars Plan A Plan B
Earnings before interest and 5,000 5,000
tax(EBIT)
Less : Interest on debt (10%) 4,000 1,000
Earnings before tax (EBT) 1,000 4,000
Less : Tax at 30% 300 1,200
Earnings available to equity B.r 700 Br. 2,800
shareholders
No. of equity shares 1,000 4,000
Earnings per share (EPS) Br. 0.7 Br. 0.7
(Earnings/No. of equity shares )
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 Solution: EPS when EBIT is Br. 12,500
Particulars Plan A Plan B
Earnings before interest and 12,500 12,500
tax(EBIT)
Less : Interest on debt (10%) 4,000 1,000
Earnings before tax (EBT) 8,500 11,500
Less : Tax at 30% 2550 3,450
Earnings available to equity Br. 5,950 Br. 8,050
shareholders
No. of equity shares 1,000 4,000
Earnings per share (EPS) Br. 5.95 Br. 2.0125
(Earnings/No. of equity shares
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 EPS and ROE Calculations
Profit after tax
Earnings per share =
Number of shares
PAT ( EBIT  INT )( 1  T )
EPS = 
N N

Profit after tax

Return on equity =
Value of equity
(EBIT  INT)(1  T )
ROE =
S

 For calculating ROE either the book value or the

market value equity may be used.

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Effect of Financial Plan on EPS and ROE: Constant EBIT
 The firm is Financial Plan
considering two Debt- All-equity
alternative financial equity (Br)
(Br)
plans:
1. Earnings before interest and 120,000 120,000
 (i) either to raise the taxes, EBIT
entire funds by issuing 2. Less: interest, INT 0 37,500
50,000 ordinary shares
at Br 10 per share, or 3. Profit before taxes, PBT = EBIT 120,000 82,500
– INT
 (ii) to raise Br 250,000
4. Less: Taxes, T (EBIT – INT) 60,000 41,250
by issuing 25,000
ordinary shares at Br 10 5. Profit after taxes, PAT = (EBIT 60,000 41,250
– INT) (1 – T)
per share and borrow Br
6. Total earnings of investors, PAT 60,000 78,750
250,000 at 15 per cent + INT
rate of interest.
7. Number of ordinary shares, N 50,000 25,000
 The tax rate is 50 per
8. EPS = (EBIT – INT) (1 – T)/N 1.20 1.65
cent.
9. ROE = (EBIT – INT) (1 – T)/S 12.0% 16.5%

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 6.3. Operating leverage
 The leverage associated with investment activities
is called as operating leverage.
 It is caused due to fixed operating expenses in the
company.
 Operating leverage may be defined as the
company’s ability to use fixed operating costs to
magnify the effects of changes in sales on its
earnings before interest and taxes.
 Operating leverage consists of two important
costs. That is fixed cost and variable cost.

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 A company is said to have a high degree of
operating leverage if it employs a great amount of
fixed cost and smaller amount of variable cost.
 Thus, the degree of operating leverage depends
upon the amount of various cost structure.
 Operating leverage can be determined with the help
of a break even analysis.
 Operating leverage can be calculated with the help
of the following formula:

Contribution
Operating
= Margin
Leverage
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 Operating leverage affects a firm’s 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
DOL 
% Change in Sales
 EBIT/EBIT
DOL 
 Sales/Sales

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Example:
 From the following selected operating data,
determine the degree of operating leverage. Which
company has the greater amount of business risk?
Why?
Company A Company B
(Br.) (Br.)
Sales 2,500,000 3,000,000
Fixed 750,000 1,500,000
 Variable expenses as a percentage of sales are
costs
50% for company A and 25% for company B.

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Solution: Statement of Profit
Company A Company B
(Br.) (Br.)
Sales 2,500,000 3,000,000
Variable cost 1,250,000 750,000
Contribution 1,250,000 2,250,000
Fixed costs 750,000 1,500,000
Operating Profit 500,000 750,000
Operating Leverage = Contribution Margin
Operating Profit
“A” Company Leverage = 1,250,000
500,000 = 2.5
“B” Company Leverage = 225,000
750,000 = 3
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 Operating leverage for B Company is higher than that
of A Company; B Company has a higher degree of
operating risk.
 The tendency of operating profit may vary
proportionally with sales, is higher for B Company
as compared to A Company.
 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.
 If any change in the sales, it will lead to
corresponding changes in profit. Operating leverage
helps to identify the position of fixed cost and variable
cost.
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 6.4. Combined Leverage
 Operating leverage affects a firm’s operating profit
(EBIT), while financial leverage affects profit after
tax or the earnings per share.
 Combined leverage is created when a company
uses both financial and operating leverage to
magnification of any change in sales into a larger
relative changes in earning per share.
 Combined leverage is also called as composite
leverage or total leverage.
 It expresses the relationship between the revenue
in the account of sales and the taxable income.

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 Combined leverage can be calculated with the help
of the following formulas:
CL = OL × FL
C OP C
CL = × =
OP PBT PBT

Where,
CL = Combined Leverage
OL = Operating Leverage
FL = Financial Leverage
C = Contribution
OP = Operating Profit (EBIT)
PBT= Profit before Tax

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 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

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 The percentage change in a firm’s earning per share
(EPS) results from one percent change in sales. This
is also equal to the firm’s degree of operating
leverage (DOL) times its degree of financial leverage
(DFL) at a particular level of sales.
Percentage change in
Degree of contributed EPS
=
coverage Percentage change in
sales

 Example: Johannes company has sales of Br.

2,500,000. Variable cost of Br. 1,250,000 and fixed
cost of Br. 50,000 and debt of Br. 1,250,000 at 8%
rate of interest. Calculate combined leverage.
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Solution
a) Statement of Profit
Sales 2,500,000
Less: Variable cost 1,500,000
Contribution Margin 1,000,000
Less: Fixed cost 500,000
Operating Profit (EBIT) 500,000
Less: Interest on Debenture( 8% of 1,250,000) 100,000
Earnings before Tax 400,000

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Solution
b) Computation of combined leverage:
i. Financial leverage = Contribution Margin
Operating Profit
= Br 1,000,000 = 2
Br 500,000
ii. Operating leverage = Operating Profit
Earnings before tax
= Br 500,000 = 1.25
Br 400,000
iii. Combined leverage:
= Operating leverage × Financial leverage
= 2 x 1.25
= 2.5
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Financial Leverage and the Shareholders’ Risk
 The variability of EBIT and EPS distinguish between two
types of risk—operating risk and financial risk.
 Operating risk can be defined as the variability of EBIT (or
return on total assets). The environment—internal and
external—in 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.

End of Chapter 6

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