Leverage

• Relationship between two interrelated variables

• Sensitiveness of one financial variable to change in another
• It is the technique which quantifies the risk return relationship of
different alternative capital structure
• Measurement of leverage between two financial variables explains
how the dependent variable responds to a particular change in
independent variable.
• The measure of this sensitiveness is expressed as a ratio is called
degree of leverage

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definition
The use of various financial instruments or borrowed capital, such as margin, to
increase the potential return of an investment

The amount of debt used to finance a firm’s assets. A firm with significance more
debt than equity is considered to be highly leveraged

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Classification
There are two types of leverage:
• Operating leverage- fixed costs are associated with running the firm
• Financial leverage- fixed costs associated with financing the firm
• Degree of leverage- measures of how much leverage the firm uses

Shahni Singh (Assistant Prof,Finance)

Measurement/ types of leverage
• Operating leverage
• Financial leverage
• Combined leverage

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Operating leverage
• Reflects the impact of change in sales on the level of operating profits
of the firm
• It consists of fixed operating costs of the company
• It implies that when there is an increase or decrease in sales level, the
EBIT also changes
• Higher DOL , more is the risk
• DOL is high when contribution is high
• More operating leverage leads to more business risk, for then a small
sales decline causes a big profit decline
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Degree of operating leverage
(DOL)
• Operating leverage- by using fixed operating costs, a small change in
sales revenue is magnified into a larger change in operating income.
• This “multiplier effect” is called the degree of operating leverage

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Financial leverage
• Financial leverage which is also known as leverage or trading on
equity, refers to the use of debt to acquire additional assets.
• The use of fixed cost sources of financing(debt, preferred stock) rather
than variable cost sources (common stock)
• It is associated with the financing activities of the company
• Refers to the relationship between EBIT and EPS
• Financial leverage depends upon the fixed costs
• The main purpose of using financial leverage is to increase the return
of equity shareholders
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Degree of financial leverage
(DFL)
• Financial leverage- by using fixed cost financing, a small change in
operating income is magnified into a larger change in earnings per
share
• This “multiplier effect” is called the degree of financial leverage

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Combined leverage
• Firm’s potentiality to use fixed cost, both operating
and financial which magnifies the effect of change in
sales volume on the EPS of the firm
• By using operating leverage and financial leverage, a
small change in sales is magnified into a larger change
in earnings per share
• This “multiplier effect” is called the degree of
combined leverage
Shahni Singh (Assistant Prof,Finance)
Degree of operating Degree of financial
leverage leverage

Degree of combined
leverage
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 Income statement
Units manufactured and sold (Q)
Selling price per unit (S)
Variable cost per unit (V)
Sales/ total revenue (Q X S)
Less- variable cost (Q X V)
Contribution (Q)
Less- fixed cost (F)
Earnings before interest and tax/ operating profit (EBIT/OP)
Less- interest on debt (I)
Earnings before tax (EBT)
Tax (T)
Earnings after tax (EAT)
Less- preference dividend (PD)
Earnings available to equity shareholders/ equity earnings
Number of equity shares (N)
Earnings per share (EPS)
Shahni Singh (Assistant Prof,Finance)
EBIT= [( Q x S) – (Q x V)] – F

EBT= EBIT – I

EAT = (EBIT – I) (1-T)= EBT(1-T)

EPS = (EAT – PD)/ N

= [EBT (1-T) – PD]/ N

Shahni Singh (Assistant Prof,Finance)