LEVERAGES

Prof. (Dr)Hanuman Prasad

Director
Faculty of Management Studies,
Mohanlal Sukhadia University, Udaipur
Rajasthan (India) +91 9414343358
 Content
- Meaning of Leverage
- Types of Leverage
- Operating Leverage
- Financial Leverage
- Combined Leverage
Meaning of Leverage

■ Leverages means Influence or power.

■ Influence of one variable over some other related financial
variable.
■ This influence in organizational set up will be possible by fixed
costs.
■ Firms ability to magnify the impact of changes in sales over
firms earnings i.e. EBIT, Earning for equity shares holders or
EPS
■ It is done through employment of assets or funds for which the
firm pays a fixed cost return.
 Types of Leverage

There are three types of leverage:

■ Operating leverage: Employment of

Assets having fixed costs -associated Relationship between sales
and EBIT
with running /operating the firm.
■ Financial leverage: Employment of
Financial resources having fixed
Relationship between
financial resources: associated with EBIT and EPS
financing the firm.
■ Combined leverage –Mixed effect of
both employment of assets and
Relationship between
financial resources Sales and EPS
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Operating Leverage
■ Operating leverage
■ Impact of change in sales on EBIT
■ Tendency of operating income (EBIT) to change
disproportionately with changes in sales volume due to
operating fixed cost.
■ Operating fixed costs do not behave like variable costs
thus do not change with sales.
■ Thus, it is firms ability to magnify impact of changes in
sales on EBIT or operating income.
■ A firm with relatively high fixed operating costs will
experience more than proportionate change in operating
income if sales change.
Degree of Operating Leverage
(DOL)
■ When we measure magnitude of disproportionate
change, it is termed as degree of leverage.

Degree of Operating Leverages

DOL

DOL DOL

DOL DOL
F= Fixed Cost
P = Sales Price per unit
V = Variable Cost per unit
What does this tell us?

■ If DOL = 2, then a 1% increase in sales will

result in a 2% increase in operating income
(EBIT).
 Break even point and operating leverage
Particulars Product A Product B
Selling Price 20 10
Variable Cost 10 6
Contribution 10 4
Total contribution 10000 4000
if sales is 1000 units
Fixed Cost 7500 2500
Profit 2500 1500
Break Even Point (FC/Cont) 7500/10 =750 units 2500/4= 625units
Operating Leverage (Cont/EBIT) 10000/2500= 4 4000/1500= 2.67

Relationship between Fixed Cost , Operating Leverage and Breakeven

Fixed Cost Operating Leverage Break even Point
High High High
Low Low Low
 Effect of operating leverage
■ More operating leverage leads to more business risk,
for then a small sales decline causes a big profit
decline.
Margin of Safety and DOL
■ Margin of safety
■ Margin of safety
■ Or
■ P Or Sales PV Ratio=Contribution
■ B Or BEP PV Ratio=Fixed Cost
■ Margin of safety

■ Or MOS
■ We know that DOL
■ Hence, Degree of Operating Leverage
Example: Leverage Vs MOS
Particulars Product C

Sales (Rs .100×1000 Units) 100000

Variable cost (60×1000 Units) 60000

Contribution 40000

Fixed Cost 30000

Profit (EBIT) 10000

Break even point (Fixed Cost/ PV Ratio) 30000/0.4=75000

Margin of Safety (100000-75000)/100000 0.25

Operating Leverage= Cont/EBIT= 40000/10000 4

Operating Leverage = 1/MOS= 1/0.25 4

Margin of Safety Business Risk DOL

Rises Falls Falls

Falls Rises Rises
 Key Points related with
Operating Leverage
■ If DOL is more than one (1), Operating Leverages exist.
■ No Fixed Cost =No Operating Leverage
■ Higher operating Level than break even: positive operating
Leverage
■ Lower operating level than break even: Negative Operating
Leverage
■ It is related to the assets side of balance sheet.
■ It is directly related to break-even point.
■ It is related to selling price and variable costs.
■ It involves business risk.
■ Business risk: is risks caused by fixed operating costs to the
business.
Assignment:
Calculate operating Leverage for
each of four firms
Particulars Firm A Firm B Firm C Firm D
Selling Price per 20 32 50 70
Unit
Variable Cost per 6 16 20 50
unit
Fixed Operating 60000 40000 100000 NiL
Cost

Assume that units sold are 5000. Find Operating

leverage and show relationship with Breakeven and
MOS
Financial Leverage

■ Financial Leverage use of funds with a fixed cost in order

to increase earning per share.
■ The use of funds obtained at a fixed cost in the hope of
increasing the return to common stockholders.
■ Using fixed cost bearing source of financing, a small
change in operating income is magnified into a larger
change in earnings per share
 Degree of Financial Leverage
(DFL)

■ The firms ability to use fixed financial charge to

magnify the effect of changes in EBIT on EPS
■ Financial Leverage (FL)
■ Financial Leverage (FL)

■ Financial Leverage (FL)

■ If DFL is more than one, financial leverage exists.
What does this tell us?

■ If DFL = 3, then a 1% increase in operating

income will result in a 3% increase in
earnings per share.
 Characteristics of Financial
Leverage
■ It is related to liabilities side of balance sheet.
■ It is the mix of methods of financing.
■ It shows effect of changes in operating profits on
earnings per share due to fixed financial charges.
■ It involves financial risk.
 Combined/Composite
Leverage
■ It may be defined as use of fixed costs, both operating and
financial, to magnify the effect of sales volume change on
the earning per share of the firm.

■ By using operating leverage and financial leverage, a small

change in sales is magnified into a larger change in earnings
per share.

■ This “multiplier effect” is called the degree of combined

leverage.
Degree of Combined Leverage

Combined Leverage = Operating Leverage (OL)

Financial Leverage (FL)

Degree Combined Leverage(DCL) = DOLDFL

What does this tell us?

■ If DCL = 4, then a 1% increase in sales will

result in a 4% increase in earnings per share.
Example:
■ Following details are available
– Sales (@100 per unit) Rs. 1200000
– Variable Cost 50%
– Fixed Cost 500000
It has borrowed Rs. 500000@10% p a and its equity share
capital is Rs. 10,00,000 (Rs. 100 Each).
Calculate
a. Operating Leverage
b. Financial Leverage
c. Combined Leverage
d. Return on Investment
e. If sales increases by R.s 600000, What will be new EBIT?
 if Change in Sales by
Solution: 600000
Sales 1200000 1800000
Variable Cost 50% 600000 900000
Contribution 600000 900000
Fixed Cost 500000 500000
EBIT 100000 400000
Less Interest 10% on 500000 50000
EBT 50000
Tax Assumed 50% 25000
EAT 25000
No of Equity 10000
EPS 2.5
a. Operating Leverage 600000/100000 6 times
b. Financial Leverage 100000/50000 2 times
c. Combined Leverage = OL*FL=6*2=12 times
d. ROI as ROE = EAT/Equity Share Fund
25000/1000000 2.5 percent
e. If sales increase by 600000 what will be EBIT
Operating Leverage= 6
OL= changes in EBIT/change in Sales
Change in EBIT=3
6=EBIT/.5 (6*0.5)
Change in EBIT will be (Increase) EBIT *3 300000 (100000*3)
THANK
YOU