Hardika Jadav

 In general, leverage refers to accomplish certain things which are otherwise not
possible i.e. lifting of heavy objects with the help of lever. This concept of
leverage is valid in business also.
 In finance, the term ‘leverage’ is used to describe the firm’s ability to use fixed
cost assets or funds to increase the return to its owners; i.e. equity
shareholders. In other words, the fixed cost funds i.e. debentures & preference
share capital act as the fulcrum, which assist the lever i.e. the firm to lift i.e.to
increase the earnings of its owner i.e. the equity shareholders.
 If earnings less the variable costs exceed the fixed costs i.e. preference dividend
& interest on debenture, or earnings before interest and taxes exceed the fixed
return requirement, the leverage is called favorable. When they do not, the
result is unfavorable leverage.
 Leverage is also the influence which an independent variable has over a
dependent/related variable i.e. rainfall over production.
 In financial context, sales & fixed cost over profit.
Leverage
 Leverage means the fixed commitment of the organization. The fixed
commitment of the organization can be classified into two different
categories viz fixed cost of operation and fixed cost of servicing.
 The fixed cost of operations are pertaining to the investment
decisions and the fixed cost of servicing with reference to the
financing decision.
 Fixed cost of operations – Investment decisions.
 Fixed cost of servicing – Financing decisions.
 If Revenues are more than the Variable Cost and Fixed Cost, that is
called favorable or otherwise unfavorable.
Types of Leverage
 Operating leverage is concerned with the relationship between the
firm’s sales revenue and its earnings before interest and taxes (EBIT)
or operating profits.
 Financial leverage is concerned with the relationship between the
firm’s EBIT and its common stock earnings per share (EPS)
 Total leverage is the combined effect of operating and financial
leverage. It is concerned with the relationship between the firm’s
sales revenue and EPS.
Breakeven analysis
 Breakeven analysis, sometimes called cost-volume-profit analysis, is
used by the firm
 A break-even analysis shows the relationship between the costs and
profits with sales volume.
 (1) to determine the level of operations necessary to cover all
operating costs and
 (2) to evaluate the profitability associated with various levels of
sales.
 The sales volume which equates total revenue with related costs and
results in neither profit nor loss is called the break –even volume or
point.
 At break –even point the fixed costs are fully recovered , any
increase in sales beyond this level will increase profit.
Operating leverage
 Operating leverage: It is a relationship in between the Sales and
Earnings before interest and taxes.
 Operating leverage is a measurement of the degree to which a firm or
project incurs a combination of fixed and variable costs.
 Operating Leverage is defined as the ability to use fixed operating
costs to magnify the effects of changes in sales on its earnings before
interest and taxes.
 Described as % change in profits accompanying the % change in
volume.
 "The firms' ability to use fixed operating costs to magnify the effects
of changes in the sales on its earnings before interest and taxes".
Degree Of Operating Leverage
 The degree of operating leverage (DOL) is used to measure the extent of the
change in operating income resulting from change in sales.
 It measures the sensitivity of the change in operating income (or EBIT,
earnings before interest and taxes) to the change in sales revenue.

Contributi on margin
Degree of operating leverage (DOL) 
Net operating income

 It basically answers the question: "By how many times will operating
profit increase or decrease in relation to the increase or decrease in
sales?"
 For example, suppose the degree of operating leverage is 3.
 A 10% increase in sales will result in a 30% increase in operating
income. A 20% increase in sales will result in a 60% increase in
operating income (i.e., 3 times the 20% increase in sales).
 If two companies have the same total revenue and same total
expenses but different cost structures, then the company with the
higher proportion of fixed costs in its cost structure will have higher
operating leverage and the company with higher proportion of
variable cost will have low operating leverage. Consider the
following two income statements of two different companies with
different cost structures.
 The Financial Leverage (FL) measures the relationship between the
EBIT and the EPS and it reflects the effect of change in EBIT on the
level of EPS. The FL measures the responsiveness of the EPS to a
change in EBIT and is defined as the % change in EPS divided by
the % change in EBIT.
 On the basis of above analysis, the Financial Leverage can be
interpreted as:
 (a)The Financial Leverage is a % change in EPS as result of 1%
change in EBIT. The FL emerges as a result of fixed financial cost
(in the form of interest and preference dividend). If there is no fixed
financial liability, there will be no FL. In such a case the % change in
EPS will be same as % change in EBIT.
 (b)A positive FL means that the firm is operating at a level of EBIT
which is higher than the financial break-even level and both the
EBIT and EPS will vary in the same direction as the EBIT changes.
 (c)A negative FL means that the firm is operating at a level lower
than the financial break-even level and the EPS will be negative.
Combined Leverage
 The Combined Leverage (CL) is not a distinct type of leverage
analysis, rather it is a product of the OL and the FL. The CL may be
defined as the % change in EPS for a given % change in the sales
level and may be calculated as follows:
The Combined Leverage is interpreted as:
 (a) The Combined Leverage is the % change in EPS resulting from a
1% change in sales level.
 (b)A positive CL means that the leverage is being computed for a
sales level higher than the break even level and both the EPS and
sales will vary in the same direction.
 (c)A negative CL means that the leverage is being calculated for a
sales level lower than the financial break even level and EPS will be
negative.