Leverages

• An increased means for accomplishing

some purpose
• Using given resources to magnify the
financial outcome
• Firm’s ability to use fixed cost fund/asset to
magnify the return to its owners
• Leverage results as a result of the firm
employing an asset / source of fund which
has a fixed cost
• Relative change in profit due to a change in
sales
• A high degree of leverage implies a large
change in profit for a relatively small change
in sales
• Higher the leverage, higher the risk and
expected return
OCC

. Equity shares

. . Preference shares

.
Corporate bonds

. Government bonds

Risk-free security

Risk
 Types of leverage
• Financial leverage
• Operating leverage
• Composite leverage
 Financial leverage
• Defined as the tendency of the residual net income
to vary disproportionately with operating profit
• Use of fixed interest bearing securities like
debenture & pref. share along with owner’s equity
capital in the capital structure
• When the interest bearing securities like debenture
& pref. share are greater as compared to equity
capital, the leverage tends to be larger
• Favorable and unfavorable financial
leverage
– Favorable when the firm earns more than the
fund cost & vice versa
• Trading on equity
• Computation FL= OP/PBT
– Equity + debt
– Pref. equity + Equity
– Pref. equity + Equity + debt
• Financial Leverage affects the EPS
(Earnings per Share) of the firm.
• Financial Leverage acts as a double-edged
sword. If the economic conditions are
favorable and EBIT is increasing, a higher
financial leverage has a positive impact on
the EPS.
• The DFL captures this relationship between
EBIT and EPS. DFL is defined as the
percentage change in EPS for a given
percentage change in EBIT.
 Operating leverage
• Defined as the tendency of the operating profit to
vary disproportionately with sales
• Said to have high operating leverage when greater
amount of fixed costs are employed than the
variable cost
• Exists when firm has to pay for fixed cost
regardless of volume of sale
• No operating leverage when there is no fixed cost
• Operating leverage reflects the extent to which
fixed assets and associated fixed costs are
utilized in the business.
• Degree of operating leverage (DOL) may be
defined as the percentage of levering.
• Operating leverage is function of 3 factors
1. Amount of fixed cost
2. Contribution margin
3. Volume of sale
• Operating leverage =
contribution /operating profit
 Composite leverage
• Express the relationship between revenue
on account of sales and taxable income

• CL=C/OP * OP/PBT = C/PBT

• Significance