FINANCIAL MANAGEMENT

OPERATING LEVERAGE & FINANCIAL LEVERAGE

SUBMITTED TO : DR. YASH PAUL SACHDEVA

Group Leader: Kashish Gupta

Team Mates: 1. Komal Chopra, 2. Devpriya Dang, 3. Abhinav, 4. Anurag Virk,
5. Sumit, 6. Manpreet Singh, 7. Arjun Tandon, 8. Rathod Vikas, 9. Ritish Raheja

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 WHAT IS LEVERAGE?
In Financial Management, ‘Leverage’ is used to
describe the ability of a firm to use fixed cost
assets or funds to increase the return to its
equity shareholders. In other words, leverage is
the employment of fixed assets or funds for which a
firm has to meet fixed costs or fixed rate of interest
obligation, irrespective of the level of activities
attained, or the level of operating profit earned.

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DEGREE OF LEVERAGE?
Leverage occurs in varying degrees. The higher the degree of leverage, the
higher is the risk involved in meeting fixed payment obligations i.e.,
Operating fixed costs and cost of debt capital. But, at the same time,
higher risk profile increases the possibility of higher rate of return to the
shareholders.

LOWER LEVERAGE HIGHER LEVERAGE

Lower effort & higher output
Higher effort & lesser output
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HOW LEVERAGE WORKS-AN EXAMPLE
A small retailer wants to expand into an available space
in a mall. In addition to increased rent, the business
will have to buy fixtures, shelves, tables, and other
operational necessities. It will also require additional
inventory. Most small businesses don't have sufficient
cash on hand to cover all these expenditures, so the
retailer applies for a business loan. This loan is
leverage. It allows the business to do what it couldn't
do without the additional funds.

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 THREE TYPES OF LEVERAGE

1. Operating leverage

2. Financial leverage

3. Combined leverage

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 DIFFERENCE BETWEEN TYPES OF LEVERAGE

OPERATIONAL Taking advantage of operations of business i.e.

LEVERAGE Operating fixed cost –rental lease payment

FINANCIAL Taking advantage of financial structure of

LEVERAGE business i.e. Fixed cost of finance-interest

COMBINED Taking advantage of operational and financial

LEVERAGE structure of business.

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HIGH OPERATING LEVERAGE COMPANY
For example, a software maker such as Microsoft. The bulk of
this company's cost structure is fixed and limited to upfront
development and marketing costs. Whether it sells one copy
or 10 million copies of its latest windows software, Microsoft's
costs remain basically unchanged. So, once the company has
sold enough copies to cover its fixed costs, every additional
dollar of sales revenue drops into the bottom line.

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 LOW OPERATING LEVERAGE COMPANY
By contrast, a retailer such as Walmart demonstrates
relatively low operating leverage. The company has fairly
low levels of fixed costs, while its variable costs are large.
Merchandise inventory represents walmart's biggest cost.
For each product sale that walmart rings in, the company
has to pay for the supply of that product.

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WHAT IS OPERATING LEVERAGE?

Operating leverage is a cost-accounting formula that

measures the degree to which a firm or project can
increase operating income by increasing revenue.

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 OPERATING LEVERAGE
1. It may be defined as the firm’s ability to use fixed
operating cost to magnify their effects of changes in sales on
its earnings before interest and taxes.
2. It is determined by the relationship between the firm’s sales
revenues and its earnings before interest and tax.
3. It is achieved by increasing sales by certain percentage.

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The formula to calculate operating leverage is-
 
Operating leverage =
OR
=
 
 Contribution= Sales-Variable Costs
 EBIT(Earnings before interest and tax)=Contribution-Fixed Costs

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UNDERSTANDING OPERATING COST
The Operating Cost Of A Firm Fall Into Three Categories:
1. FIXED COSTS- Which don’t vary with sales volume. Example
rental lease payments, salaries, depreciation.
2. Variable costs- Which vary directly with sales. Example direct
labour costs, cost of raw materials used in production etc.
3. Semi-variable/semi fixed costs- Which are partly fixed and
partly variable. Example repairs, monthly telephone charges,
indirect materials, indirect labour, fuel and power.
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 ILLUSTRATION 1 OF OPERATING LEVERAGE 

From the following selected   Company A Company B

(Rs) (Rs)
operating data, determine
operating leverage.
Sales 25,00,000 30,00,000
Variable expenses as a
percentage of sales are 50% Fixed 7,50,000 15,00,000

for company A and 25% for Cost

company B.

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 SOLUTION OF
OPERATING   Company Company
LEVERAGE A B
 ILLUSTRATION Sales 25,00,000 30,00,000
1 Less: 12,50,000 7,50,000
Variable cost
Contribution 12,50,000 22,50,000
Less: Fixed 7,50,000 15,00,000
STATEMENT cost
OF PROFIT Operating 5,00,000 7,50,000
profit
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 SOLUTION OF OPERATING
LEVERAGE EXAMPLE 1
 
Operating leverage=

Company A= 12,50,000 = 2.5

5,00,000

Company B= 22,50,000 = 3
7,50,000

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 CHARACTERISTICS OF OPERATING
LEVERAGE 

1. It is related to the assets side of balance sheet

2. It is directly related to break-even point.
3. It is related to selling price and variable costs.
4. It involves business risk.

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DEGREE OF OPERATING LEVERAGE

The operating leverage measures the relationship

between the sales revenue and the EBIT or in
other words it measures the effect of change in
sales revenue on the level of EBIT.

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The degree of operating leverage is calculated as-
Degree of Operating leverage=
EBIT= Q(S-V)- F
Q= Quantity Product
S= Selling Expenses
F= Fixed Expenses
V= Variable Expenses

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 DEGREE OF OPERATING LEVERAGE

1. The greater the DOL, the higher the operating leverage.

2. Since DOL depends on fixed operating costs, it largely follows

that the larger the fixed operating costs, the higher is the
degree of operating leverage of the firm.

3. Higher operating leverage is good when revenues are rising

and bad when they are falling.

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Illustration-2
The management of ABC Corp. wants to determine the company’s
current degree of operating leverage. The company sells 10,000
product units at an average price of Rs 50. The variable cost per
unit is Rs 12, while the total fixed costs are Rs 100,000.
Degree of Operating Leverage=
=1.38
The DOL indicates that every 1% change in the company’s sales
will change the company’s operating income by 1.38%.

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Illustration 3
Let us take the example of Company A, which has clocked
sales of Rs 8,00,000 in year one, which further increased to
Rs 10,00,000 in year two. In year one, the 
operating expenses of the company stood at Rs 4,50,000,
while in year two, the same went up to Rs 5,50,000.
Determine the DOL for Company A.

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   Company  
USE THE
FOLLOWING
A
DATA FOR THE
CALCULATION
OF THE Particulars Year 1 Year 2
DEGREE OF OL-
Sales 8,00,000 10,00,000

Operating 4,50,000 5,50,000

Expenses
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  Degree of Operating leverage=

Step 1. Year 1 Step 2. Year 2

EBIT= Rs (10,00,000 – 5,50,000)

EBIT = Sales – Operating expenses
EBIT in year 2 = Rs 4,50,000
= Rs (8,00,000 – 4,50,000)

= Rs 3,50,000 Step 3. Change in EBIT = EBIT in

year 2 – EBIT in year 1

= Rs (4,50,000 – 3,50,000)

= Rs1,00,000

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Step 4. Percentage change in EBIT
Step 5. Change in sales = Sales in
= Change in EBIT / EBIT in year 1
year 2 – Sales in year 1
x 100%
= Rs (10,00,000 – 8,00,000)
= Rs 100,000 / Rs 350,000 x 100%
= Rs 2,00,000
= 28.57%
Step 6. Percentage change in sales

= Change in sales / Sales in year 1

x 100%

= Rs 2,00,000 / 8,00,000 x 100%

= 25.00%

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Now, DOL Formula = Percentage change in EBIT / Percentage change in sales

DOL Formula= 28.57% / 25.00%

= 1.14

Therefore, the DOL of Company A is 1.14

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 SIGNIFICANCE OF OPERATING LEVERAGE

1. Improvement in company’s utility: it allows improving

the company’s utility in A highly efficient way, allowing the
largest number of services and products not to have an
impact that raises costs in the same proportion.
2. Analysis of cash flows: it helps the company to more
accurately project and analyze its cash flows by taking into
account the fixed cost it will pay during the year.
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 SIGNIFICANCE OF OPERATING LEVERAGE

3. Control: it generates greater control over the costs that are

incurred for production.
4. Changes in sales: it gives an idea about the impact of
changes in sales on the operating income of the firm.
5. Expansion of profit: high degree of operating leverage
indicates increase in operating profit or EBIT.

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SIGNIFICANCE OF OPERATING LEVERAGE

6. EBIT: High degree of operating leverage magnifies the

effect on EBIT for A small change in the sales volume.
7. Low margin of safety: High operating leverage
results from the existence of a higher amount of fixed
costs in the total cost structure of a firm which makes
the margin of safety low.  

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 LIMITATIONS OF OPERATING LEVERAGE

1. Magnification of losses to the shareholders if the firm is not

profitable .
2. High capital cost of equipment and the liquidity of such an
investment make it :
 Expensive ( more difficult to finance )
 Potentially exposed to technological obsolescence, etc .

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 LIMITATIONS OF OPERATING LEVERAGE

3. Higher break even point.

4. It increases that the risk of a process error can damage the
entire production line.
5. With so many large volumes fixed costs, a liquidity problem
may arise in the event of the termination of a sale.

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WHAT IS FINANCIAL LEVERAGE?
The use of long-term fixed interest bearing debt and preference share capital
along with equity share capital is called financial leverage or trading on
equity.
Aim of financial leverage- To increase the revenue available for equity
shareholders using the fixed cost funds. If the revenue earned by employing fixed
cost funds is more than their cost (interest and/or preference dividend) then it will
be to the benefit of equity shareholders to use such a capital structure.

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FINANCIAL LEVERAGE
A firm is known to have a favourable leverage if its earnings are more than
what debt would cost. On the contrary, if it does not earn as much as the
debt costs, then it will be known as an unfavourable leverage.

1. When the amount of debt is relatively large in relation to the capital stock,
a company is said to e trading on thin equity.

2. When the amount of debt is comparatively low in relation to capital

stock, a company is said to be trading on thick equity.

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IMPACT OF FINANCIAL LEVERAGE
1. The financial leverage is used to magnify the shareholders Earnings.
2. It is based on the assumption that the fixed charges/costs funds can
be obtained at a cost lower than the firm’s rate of return on its assets.
3. When the difference between the earnings from assets financed by
fixed cost funds and the cost of these funds are distributed to the
equity shareholders, they will get additional earnings without
increasing their own investment. Consequently, the earnings per share
and the rate of return on equity share capital will go up.

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IMPACT OF FINANCIAL LEVERAGE
4. On the contrary, if the firm acquires fixed cost funds at a higher cost
than the earnings from those assets then the earnings per share and
the return on equity capital will decrease.

5. The impact of financial leverage can be analysed while looking at the

earnings per share and return on equity capital.

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Illustration 1

A Ltd. company has equity share capital of Rs. 5,00,000 divided into shares of
Rs. 100 each. It wishes to raise further Rs. 3,00,000 for expansion cum
modernisation plans. The company plans the following financial schemes.
1. All common stock
2. Rs. One lakh in common stock and Rs. two lakh in 10% debentures.
3. All debt at 10% p.a.
4. Rs. One lakh in common stock and Rs. two lakh in preference capital with
the rate of dividend at 8%.
The company’s expected earnings before interest and tax (EBIT) are Rs.
1,50,000. The corporate rate of tax is 50%.
You are required to determine the earnings per share (EPS) in each plan and
comment on the implications of financial leverage.
 
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  PLAN 1 PLAN 2 PLAN 3 PLAN 4
  Rs. Rs. Rs. Rs.
Earnings before interest 1,50,000 1,50,000 1,50,000 1,50,000
and tax        
Less: interest - 20,000 30,000 -

  1,50,000 1,30,000 1,20,000 1,50,000

Less: tax @50% 75,000 65,000 60,000 75,000
Earnings after tax 75,000 65,000 60,000 75,000
Less: preference        
dividend @8% - - - 16,000

Earnings available for 75,000 65,000 60,000 59,000

common stockholders
No. Of shares 8,000 6,000 5,000 6,000
Earnings per share Rs. 9.375 Rs. 10.83 Rs. 12 Rs. 9.83

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CHARACTERSTICS OF FINANCIAL LEVERAGE:

1. It is related to the liabilities side of the balance sheet.

2. It involves mix methods of financing.
3. It shows effect of changes in operating profits on earnings per share
due to fixed financial charges.
4. It involves financial risk.

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DEGREE OF FINANCIAL LEVERAGE
1. It is a financial ratio which measures the sensitivity of a company’s overall
profitability to the volatility of operating income caused by change in its capital
structure.

2. DFL is used to quantify a company’s financial risk

3. A high degree of financial leverage indicates that even a small change in the
company’s leverage may result in A significant fluctuation in the company’s
profitability. 

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1. A company’s management often wants to decide
whether it should or should not issue more debt. In
such a case, net income would be an appropriate
measure of the company’s profitability.

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2. If an investor wants to determine the effects of the company’s

decision to incur additional leverage, the earnings per share
(EPS) is a more appropriate figure because of the metric’s strong
relationship with the company’s share price.

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3. Calculating the degree of financial leverage in a
particular time period.

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ILLUSTRATION 1
• ABC Corp. is preparing to launch a new project that will require substantial external financing.
The company’s management wants to determine whether it can safely issue a significant
amount of debt to finance the new project. Currently, the company’s EBIT is $500,000, and
interest payments are $100,000.
• In order to make the decision, the company’s management wants to examine its degree of
financial leverage ratio

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ILLUSTRATION 2

A company named ABC borrowed Rs.40000 at the rate of

interest 10%.The total number of shares are 1000 and
income before tax and interest is Rs.5000 with tax rate of
50% on EBT. If there is 100% increase in the EBIT of the
company then find the degree of financial leverage.

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SOLUTION
Scenario 1 Amount (Rs.) Scenario 2 Amount (Rs.)

EBIT 5000 EBIT 10,000

LESS-INTREST (4000) LESS-INTREST (4000)
EBT 1000 EBT 6000
LESS –TAX (500) LESS –TAX (3000)
EAESH 500 EAESH 3000
NO. OF SHARES 1000 NO. OF SHARES 1000
EPS 0.5 EPS 3

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SOLUTION

% CHANGE IN EBIT=100%
% CHANGE IN EPS=(3-0.5/0.5)*100 =500%
DFL= % CHANGE IN EPS/ % CHANGE IN EBIT
DFL= 500/100=5

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SIGNIFICANCE OF FINANCIAL LEVERAGE
Financial leverage is employed to plan the ratio between debt and equity so
that earning per share is improved. Following is the significance of financial
leverage:

1. Planning of capital structure: The capital structure is concerned

with the raising of long term funds, both from share holders and long
term creditors. A financial manager has to decide about the ratio
between fixed cost funds and equity share capital. The effect of
borrowing on cost of capital and financial risk have to be discussed
before selecting A final capital structure.

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2. Profit planning: The earning per share is affected by the degree of financial
leverage. If the profitability of the concern is increasing then fixed cost funds
will help in increasing the availability of profits for equity stockholders.
Therefore, financial leverage is important for profit planning. The profitability
level of sales and resultant is helpful in profit planning. An important tool of
profit planning is break-even analysis. The concept of break-even analysis is
used to understand financial leverage. So, financial leverage is very important
for profit planning.

3. Ideal for acquisitions: Because of the additional cost and risks of bulking
up on debt, leveraged finance is best suited for brief periods where your
business has a specific growth objective, such as conducting an acquisition,
management buyout, share buyback or a one-time dividend.

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4. Acts as a Guideline: It acts as useful guideline in setting the
maximum limit by which business of the firm should be
expanded. For example, management is advised to stop
expanding business the moment anticipated return on
additional investment falls short of fixed charges of debt.

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LIMITATIONS OF FINANCIAL LEVERAGE

The Financial Leverage Suffers From The Following Limitations:

1. Double-edged weapon: Financial leverage is A double-edged weapon. It

can be successfully employed to increase the earnings of the shareholders
only when the rate of earnings of the company is more than the fixed rate
of interest/dividend on debentures/preference shares. On the other hand,
if it does not earn as much as the cost of interest bearing securities, then it
will work adversely and hence cannot be employed.

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2. Beneficial only to companies having stability of earnings: Financial
leverage is beneficial only to the companies having stable and regular
earnings. This is so because interest on debentures is A recurring burden on
the company and the company having irregular income cannot pay interest on
its borrowing during lean years.

3. Increases risk and rate of interest: Another limitation of trading on equity

is on account of the fact that every rupee of extra debt increases the risk and
hence the rate of interest on subsequent loans also goes on increasing. It
becomes difficult for the company to obtain further debts without offering
extra securities and higher rates of interest reducing their earnings.

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4. Restrictions from financial institutions: The financial
institutions also impose restrictions on companies which resort to
excessive trading on equity because of the risk factor and to
maintain A balance in the capital structure of the company.

5. More costly: Leveraged finance products, such as leveraged

loans and high yield bonds, pay higher interest rates to
compensate investors for taking on more risk.

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COMPARISON CHART DEPICTING
DIFFERENCE BETWEEN OPERATING
LEVERAGE AND FINANCIAL LEVERAGE

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BASIS FOR OPERATING LEVERAGE FINANCIAL LEVERAGE
COMPARISON

Meaning Use of such assets in the company's Use of debt in a

operations for which it has to pay company's capital
fixed costs is known as Operating structure for which it has
Leverage. to pay interest expenses
is known as Financial
Leverage.
Measures Effect of Fixed operating costs. Effect of Interest
expenses

Relates Sales and EBIT EBIT and EPS

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BASIS FOR OPERATING LEVERAGE FINANCIAL LEVERAGE
COMPARISON

Ascertained Company's Cost Structure Company's Capital Structure

by

Preferable Low High, only when ROCE is higher

Formula DOL = Contribution / EBIT DFL = EBIT / EBT

Risk It give rise to business risk. It give rise to financial risk.

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CONCLUSION
Operating leverage and financial leverage are both critical in their own terms. And they
both help businesses in generating better returns and reduce costs. So the question
remains can a firm use both of these leverages? The answer is yes.
If a company can use its fixed costs well, they would be able to generate better returns
just by using operating leverage. And at the same time, they can use financial leverage
by changing their capital structure. Even if changing the capital structure would prompt
the company to pay interests; still, they would be able to generate a better rate of
returns and would be able to reduce the amount of taxes at the same time.
That’s why using operating leverage and financial leverage is a great way to improve the
rate of returns of the company and to reduce the costs during a particular period.

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 WHAT IS COMBINED LEVERAGE
1. Company uses both financial and operating leverages for
magnification of any change in sales into a larger relative
changes in earning per share.
2. Combined leverage is also called as composite leverage or
total leverage.
3. Combined leverage express the relationship between the
revenue in the account of sales and the taxable income.
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 COMBINED LEVERAGE FORMULA

COMBINED LEVERAGE=OPERATING LEVERAGE X

FINANCIAL LEVERAGE
• 
OR

OR
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DEGREE OF COMBINED LEVERAGE
Degree of combined leverage measures the percentage
change in earnings per share due to percentage change
in sales.

The formula for the degree of combined leverage is-

 DCL= DOL x DFL

Where- DOL= degree of operating leverage & DFL= degree of financial leverage

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 DEGREE OF COMBINED LEVERAGE
FORMULA

OR DCL= X

• 
OR DCL=

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 DEGREE OF COMBINED LEVERAGE
1. It summarizes the effects that the combined degree of operating
leverage and degree of financial leverage have on a company's
earnings per share, based on a given change in shares.
2. The ratio helps a company find its best possible levels of
operating and financial leverage.
3. The formula helps companies understand how the combined
leverage affects the company's total earnings.

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ILLUSTRATION

KUMAR COMPANY HAS SALES OF RS 25,00,000. VARIABLE

COSTS OF RS 15,00,000 AND FIXED COSTS OF RS 5,00,000
AND DEBT OF RS 12,50,000 AT 8% RATE OF INTEREST.
CALCULATE COMBINED LEVERAGE.

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 STATEMENT OF PROFIT-

Sales 25,00,000
Less: Variable cost 15,00,000
Contribution 10,00,000
SOLUTION- Less: Fixed cost 5,00,000
Operating profit 5,00,000

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 Operating leverage=

=10,00,000/5,00,000 = 2
 
 Financial leverage =
 
EBIT=5,00,000
Less int on debt(8% of 12,50,000)=1,00,000
EBT=4,00,000
FL=5,00,000/4,00,000=1.25

Combined Leverage=OL X FL  Also, Combined leverage =

Combined Leverage=2 x 1.25= 2.5 10,00,000/ 4,00,000= 2.5
 
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ILLUSTRATION

A firm's sales, variable costs and fixed cost amount to ₨ 75,00,000, ₨ 42,00,000 and ₨
6,00,000 respectively. It has borrowed ₨ 45,00,000 at 9 percent and its equity capital total
₨ 55,00,000

A) What is the firm's ROI?

B) What are operating, financial and combined leverages of the firm?
C) If sales drop to ₨ 50,00,000 what will the new EBIT be?
D) At what level will the EBT of the firm equal to zero?

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 SOLUTION
 B) Operating leverage=
A)ROI = Sales revenue – VC = Contribution
= = 1.22
ROI =  = 0.27  Financial leverage = Contribution – FC = EBIT
• 
ROI = 27% = = 1.18 EBIT - Interest = EBT

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Combined leverage =
= = 1.44
Alternatively, OL × FL = 1.22 × 1.18 = 1.44
C) EBIT at sales level of ₨ 50 lakh
Sales revenue  = ₨ 50,00,000
Variable costs ( 50,00,000 × 0.56) = 28,00,000
Fixed costs= 6,00,000

EBIT = Sales – VC – FC = 50,00,000 – 28,00,000 – 6,00,000 = ₨ 16,00,000

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 D) Zero EBT implies break- even sales (BSER)

CV Ratio= = 0.44

BSER = (6,00,000 + 4,05,000)÷0.44 = 22,84,091

Confirmation Table

Sales revenue 22,84,091

Less: VC(0.56) 12,79,091

Less: FC (operating) 6,00,000

Less: Interest 4,05,000

EBT Zero

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THANKYOU

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