FINANCIAL SOURCING AND ANALYSIS

Leverage Analysis
 Leverage Analysis

 Leverage is an investment strategy of using borrowed money—specifically, the use of various financial instruments or 
borrowed capital—to increase the potential return of an investment.

 Leverage can also refer to the amount of debt a firm uses to finance assets.

 Leverage results from using borrowed capital as a funding source when investing to expand the firm's asset base and generate
returns on risk capital.

 Leverage refers to the use of debt (borrowed funds) to amplify returns from an investment or project.

 Investors use leverage to multiply their buying power in the market.

 Companies use leverage to finance their assets—instead of issuing stock to raise capital, companies can use debt to invest in
business operations in an attempt to increase shareholder value. 
 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.

 Leverage is the use of debt (borrowed capital) in order to undertake investment or project.
The result is to multiply the potential returns from a project. At the same time, leverage will
also multiply the potential downside risk in case the investment does not pan out.

 When one refers to a company, property, or investment as "highly leveraged," it means that
item has more debt than equity.
 The concept of leverage is used by both investors and companies.

 Investors use leverage to significantly increase the returns that can be provided on an
investment. They lever their investments by using various instruments, including options,
futures, and margin accounts.

 Companies can use leverage to finance their assets. In other words, instead of issuing stock to
raise capital, companies can use debt financing to invest in business operations in an attempt
to increase shareholder value. 
Investors who are not comfortable using leverage directly have a variety of ways to
access leverage indirectly. They can invest in companies that use leverage in the normal
course of their business to finance or expand operations—without increasing their outlay.
 LEVERAGE

Operating Financial Combined

Leverage Leverage Leverage
 Leverage Analysis Calculation

Sales

Operational
Contribution (Sales-variable cost) Leverage

EBIT (Contribution- Fixed cost)

Combined
EBT (EBIT-Interest) Leverage

EAT (EBT- Tax)

Financial
ESESH (EAT- Preferential Debenture) Leverage

EPS
 Operating Leverage

 Operating leverage refers to the use of fixed costs in operations and it is

related to the firm's production processes.

 The greater the operating leverage the higher is the risk in operations.

At the same time, a high degree of operating leverage causes profits to

rise rapidly after the break-even point is reached.

 Sales

Contribution (Sales-variable cost)

EBIT (Contribution- Fixed cost)

 Sales - Variable cost Contribution - Fixed cost

Sales Contribution EBIT

𝑁𝑜.𝑜𝑓 𝑢𝑛𝑖𝑡𝑠𝑠𝑜𝑙𝑑×𝐴𝑣𝑒𝑟𝑎𝑔𝑒𝑝𝑟𝑖𝑐𝑒𝑝𝑒𝑟𝑢𝑛𝑖𝑡

Fixed cost + Variable

Cost
 Financial Leverage

Financial leverage refers to the use of debt in financing non-current assets.

If the return on assets exceeds the cost of debt, the leverage is successful i.e., it improves
returns on equity. While this being so, a high financial leverage magnifies financial risk.
 At some degree of financial leverage the cost of debt rises because of increased risk
with the higher fixed charges. When this happens, riskiness of the firm also increases in
the eyes of equity investors who start expecting a higher return to compensate for the
increased risk burden.
Financial leverage and operating leverage are related with each other.
Both have similar effects on profits. A greater use of either i.e., operating
or financial leverage leads to following results:
 The break-even point is raised

 The impact of change in the level of sales on profits is magnified.

 EBIT

EBT (EBIT-Interest) Fixed

EAT (EBT- Tax)

ESESH (EAT- Preferential Debenture) Fixed

EPS
 Operating and financial leverages have reinforcing effects.

 Operating, or first-stage leverage affects earnings before interest and taxes (i.e., net
operating income) while financial, or second-stage leverage affects earnings after
interest and taxes (i.e., net income available to equity shareholders).
 Operational Cost

 Companies incur two types of production / operational costs: variable costs and fixed costs.

 Variable costs vary based on the amount of output produced.

 Variable costs may include labor, commissions, and raw materials.

 Fixed costs remain the same regardless of production output.

 Fixed costs may include lease and rental payments, insurance, and interest payments.
Unlike variable costs, a company's fixed costs do not vary with the volume of

production. Fixed costs remain the same regardless of whether goods or

services are produced or not. Thus, a company cannot avoid fixed costs.
Thank You