Measures of Leverage

Abhishek Sinha
 Item Amount (Rs.)
Total Revenue 25,00,000
Less: Operating Expenses (V) 1900000
Earnings Before Interest & Tax (EBIT) 6,00,000
Less: Interest on Debt (I) 75,000
Profit Before Tax (PBT) 5,25,000
Less:Tax @ 50% (T) 2,62,500
Profit After Tax (PAT) 2,62,500
Less: Preference dividend (Dp) 50,000
Equity Earnings 2,12,500
 Item Amount (Rs.)
Total Revenue 25,00,000
Less: Variable Expenses (V) 10,00,000
Fixed Expenses (F) 9,00,000
Earnings Before Interest & Tax (EBIT) 6,00,000
Less: Interest on Debt (I) 75,000
Profit Before Tax (PBT) 5,25,000
Less:Tax @ 50% (T) 2,62,500
Profit After Tax (PAT) 2,62,500
Less: Preference dividend (Dp) 50,000
Equity Earnings 2,12,500
Operating Profit, Profit available to Equity
Shareholders
• EBIT = ((No. of units sold) * Selling Price) – ((No. Of units* Variable
Cost)) – Fixed Cost
= No. of Units sold * ((Selling Price – Variable Cost) – Fixed Cost))
PAT = No. of Units sold * ((Selling Price – Variable Cost) – Fixed Cost))
- Interest
- Tax
- Dividend Paid to Preference Shareholders
EPS = PAT/ No. of Equity Shares Outstanding
Overview
• Introduction
• Importance of Leverage
• Measures of Leverage
• Cost Structure
• Business Risk
• Operating Risk
• Degree of Financial Leverage
• Total Leverage
• Break Even Point
Simply put
• Leverage - fixed costs in a company’s cost structure.
• Fixed costs that are operating costs (such as salaries, depreciation or
rent) create operating leverage.
• Fixed costs that are financial costs (such as interest expense) create
financial leverage.
• Fixed costs act as a fulcrum for the company’s earnings.
• Leverage - magnifies impact on earnings both up and down.
Importance of Leverage
• Helps Assess company’s risk and return characteristic
• Helps analyst understand a company’s business and future prospects
from management’s decisions about the use of operating and
financial leverage
• Understanding a company’s use of leverage should help in forecasting
cash flows and in selecting an appropriate discount rate for finding
their present value.
Measures of Leverage
• Leverage increases the volatility of a company’s earnings and cash
flows and increases the risk of lending to or owning a company.
• The greater a company’s leverage, the greater its risk and, hence, the
greater the discount rate that should be applied in its valuation.
• The valuation of a company requires forecasting future cash flows and
assessing the risk associated with those cash flows.
Mathematically what is Leverage
• Leverage in terms of financial analysis is the influence which an independent financial variable has over a
dependent/related financial variable.
• When leverage is measured between two financial variables it explains how the dependent variable responds to a
particular change in the independent variable
• Leversge of Y/ Leverage of L X =
•  
where
•
(ΔY/Y/ ΔX/X
•
LY/LX – measure of the leverage which dependent Y has with independent X
• DX – change in X
• DY – change in Y
• D X/X – percentage change in X
• DY/Y – percentage change in Y
Operating Leverage

• Operating leverage examines the effect of the change in the quantity produced (independent variable ) (x)
on the EBIT of the company (Dependent Variable) and is measured by calculating the Degree of Operating
Leverage (DOL).

• DOL = Percentage change in EBIT/Percentage change in Output

• = (ΔEBIT/EBIT)/ ΔQ/Q
• From Eq(i) EBIT = Q(S – V) – F
• Substituting for EBIT, we get
• DOL = [Q(S – V)] / [Q(S – V) – F]
Illustration

•Calculate the DOL for XYZ Company Ltd. given the following additional
information:
•DOL of XYZ Company Ltd.
•DOL = [Q(S – V)] / [Q(S – V) – F]
•= [5,000(500 – 200)]/[5,000(500 – 200) – 9,00,000] = 2.50

Quantity = 5,000
Variable cost per unit = Rs.200

Selling price per unit = Rs.500

Fixed asset = Rs.9,00,000

 Illustration
Bell Metal Works Fibre Glass Limited

Units Produced & Sold   Total Operating Cost   Units Produced & Sold   Total Operating Cost  
Sales EBIT Sales EBIT
Q PQ     Q PQ    
      (In Rupees)     (In Rupees)  
10,000 1,00,000 1,60,000 (60,000) 10,000 1,00,000 2,40,000 (1,40,000)
20,000 2 ,00,000 2,30,000 (30,000) 20,000 2,00,000 2,90,000 (90,000)
30,000 3,00,000 3,00,000 0 30,000 3,00,000 3,40,000 (40,000)
40,000 4,00,000 3,70,000 30,000 40,000 4,00,000 3,90,000 10,000
50,000 5,00,000 4,40,000 60,000 50,000 5,00,000 4,40,000 60,000
60,000 6,00,000 5,10,000 90,000 60,000 6,00,000 4,90,000 1,10,000
70,000 7,00,000 5,80,000 1,20,000 70,000 7,00,000 5,40,000 1,60,000
80,000 8,00,000 6,50,000 1,50,000 80,000 8,00,000 5,90,000 2,10,000

Unit Selling Price (P) = Rs.10   Unit Selling Price (P) = Rs.10  

Operating Fixed Costs (F) = Rs.90,000 Operating Fixed Costs (F) = Rs.1,90,000

Unit Variable Operating Cost (V) = Rs.7 Unit Variable Operating Cost (V) = Rs.5

EBIT Break-even Point = 30,000 units EBIT Break-even Point = 38,000 units
Interpretation
We can see that Bell Metal Works has lower fixed costs and higher variable cost per
unit when compared to Fibre Glass Limited.
The selling price per unit (P) of both firms is the same, viz., Rs.10. An interesting
point we notice is that at an output of 50,000 units both firms have the same profit
i.e., Rs.60,000.
However, as sales fluctuate, the EBIT of Bell Metal Works fluctuates far less than the
EBIT of Fibre Glass Limited.
This brings us to the conclusion that the DOL of Fibre Glass Limited is greater than
the DOL of Bell Metal Works.
Let us compute the DOL of these two firms at an output of 50,000 units.
For Bell Metal Works:
DOL = [50,000 (10 – 7)] / [50,000 (10 – 7) – 90,000]
= 2.5
For Fibre Glass Limited:
DOL = [50,000 (10 – 5)] / [50,000(10 – 5) – 1,90,000]
= 4.17
BUSINESS RISK
• Business risk is the risk associated with operating earnings.
• Operating earnings are risky because total revenues are risky, as are the
costs of producing revenues.
• Revenues are affected by a large number of factors, including economic
conditions, industry dynamics (including the actions of competitors),
government regulation, and demographics.
• Therefore, prices of the company’s goods or services or the quantity of
sales may be different from what is expected.
• Uncertainty with respect to the price and quantity of goods and
services as sales risk.
Operating Risk
• Operating risk is the risk attributed to the operating cost structure, in
particular the use of fixed costs in operations
• The greater the fixed operating costs relative to variable operating
costs, the greater the operating risk
• Business risk is therefore the combination of sales risk and operating
risk.
• Companies that operate in the same line of business generally have
similar business risk.
Operating Risk

• We refer to the risk arising from the mix of fixed and variable costs as
operating risk.
• The greater the fixed operating costs relative to variable operating
costs, the greater the operating risk.
• DOL = Percentage change in operating income
Percentage change in units sold
• DOL = Q(P - V )
Q(P - V ) - F
Operating Leverage – Industry Perspective
• Industries that tend to have high operating leverage are those that
invest up front to produce a product but spend relatively little on
making and distributing it.
• Software developers and pharmaceutical companies fit this
description. Can you name a few more?
• Alternatively, retailers have low operating leverage because much of
the cost of goods sold is variable.
Financial Risk
Financial risk is the risk associated with how a company finances its
operations.
Debt – increases financial risk
A company is legally obliged to pay interest
A company is not legally obliged to pay dividends
By taking on fixed obligations, such as debt and long-term leases, the
company increases its financial risk
If a company finances its business with common equity, generated either
from operations (retained earnings) or from issuing new common shares, it
does not incur fixed obligations
degree of
financial
leverage (DFL)
• The financial leverage
measures the effect of the
change in EBIT on the EPS
of the company DFL = (Change in EPS/EPS)/(
Change in EBIT/EBIT)
• DFL = EBIT/ (EBIT-1) –
Dp/(1-T)
Illlustration Capital Structure Amount (Rs.)

Authorized Issued and Paid-up  

• Take the example of XYZ Capital
Company Ltd., which has an 500000 Equity Shares @ Rs.10 50,00,000
EBIT of Rs.6,00,000 at 5,000 each
level of production, Tax Rate
50%. The capital structure of 15% Debentures 5,00,000
the company is as follows:
10% Preference Shares  
5000 Preference Shares @ 5,00,000
Rs.100
Total 60,00,000
Solution

Earnings Before Interest and Tax (EBIT) = Rs.6,00,000

Interest on Long-term Debt (I) = Rs.75,000
Preference Dividend (Dp)
= Rs.50,000
Corporate Tax (T) = 50%
DFL = (6,00,000)/ ((600000-75000-50000)/(1-0.5)) = 1.41
Financial Leverage and Risk
• If increased financial leverage leads to increased return on equity, why
do companies not resort to ever increasing amounts of debt financing?
• Why do financial and other term lending institutions insist on norms
for Debt-Equity Ratio?
• The answer is that as the company becomes more financially
leveraged, it becomes riskier, i.e., increased use of debt financing will
lead to increased financial risk which leads to:
• Increased fluctuations in the return on equity.
• Increase in the interest rate on debts.
Financial Leverage and Risk
• If increased financial leverage leads to increased return on equity, why
do companies not resort to ever increasing amounts of debt financing?
• Why do financial and other term lending institutions insist on norms
for Debt-Equity Ratio?
• The answer is that as the company becomes more financially
leveraged, it becomes riskier, i.e., increased use of debt financing will
lead to increased financial risk which leads to:
• Increased fluctuations in the return on equity.
• Increase in the interest rate on debts.
 Unleveraged Firm Leveraged Firm
(zero Debt) (Debt-Equity
Ratio 2 : 1)
Sales 9,000 9,000
Expenses 7,000 7,000
EBIT 2,000 2,000
Impact pf Interest Charges – 1,000
(6667 x 0.15)
Financial Leverage  
PBT
 
2,000 1,000
Tax @50% 1,000 500
Net Profit 1,000 500
Net Profit at Sales of Rs.10,000 1,500 1000
ROE at Sales of Rs.10,000 15% 30%
ROE at Sales of Rs.9,000 10% 15%
Total Leverage
• A combination of the operating and financial leverages is the total or combined leverage. Thus, the
degree of total leverage (DTL) is the measure of the output and EPS of the company. DTL is the
product of DOL and DFL and can be calculated as follows:
• DTL = % change in EPS / % change in output
• = (DEPS/EPS)/(DQ/Q)
• DTL = DOL x DFL

Q (S - V)
= Q(S - V) - F - I – D/ (1 - T)
 Iliustration

• Calculating the DTL for XYZ Co. Ltd. Equity Earnings (PAT after = Rs.1,62,500
given the following information distributing dividends)
• DTL= Quantity Produced (Q) = 5000 Units
Q (S - V)
Variable Cost per unit (V) = Rs.200
= Q(S - V) - F - I – Selling Price per unit (S) = Rs.500
D 1 - T)
/?

Number of Equity   5,00,000

Shareholders (N)
• 5, 000 (500 - 200)
5, 000 (500 - 200) - 9, 00, 000 - 75, Fixed Expenses (F) = Rs.9,00,000
000- 50000/(1-0.5) = 3.53
Interest (I) = Rs.75,000
DTL = DOL *DFL
Preference Dividend (Dp) = Rs.50,000
Corporate Tax (T) = 50%
DFL
• The following observations can be made from the above calculations:
• There is a unique DTL for every level of output.
• At the overall break-even point of output the DTL is undefined.
• If the level of output is less than the overall break-even point, then the DTL will be negative.
• If the level of output is greater than the overall break-even point, then the DTL will be positive. DTL
decreases as Q increases and reaches a limit of 1
Break Even Point
• There is a number of units at which the com pany goes from being
unprofitable to being profitable—that is, the number of units at which
the net income is zero
• This number is referred to as the breakeven point.
• The breakeven point, QBE, is the number of units produced and sold
at which the company’s net income is zero—the point at which
revenues are equal to costs.
• PQ = VQ + F + C
 B

Quantity sold to breakeven

E Q =F+CP-V

• Breakeven Quantity
Q = F+C/P-V
• Operating Breakeven Quantity
Q= F/P-V
Risks of Creditors and Owners
• The risk for providers of equity and debt capital differs because of the relative rights
and responsibilities associated with the use of borrowed money in a business.
• Lenders have a prior claim on assets relative to shareholders, so they have greater
security.
• In return for lending money to a business, lenders require the payment of interest
and principal when due.
• These payment have to be made irrespective of profits
• The risk for providers of equity and debt capital differs because of the relative rights
and responsibilities associated with the use of borrowed money in a business.
• In contrast, equity providers claim whatever is left over after all expenses, including
debt service, have been paid.