Chapter 6

Operating and Financial

Leverage
Chapter 5 - Outline

What is Leverage?
Break-Even (BE) Point
Operating Leverage
Financial Leverage
Leverage Means Risk
Combined or Total Leverage
What is Leverage?
Use of special forces and effects to magnify or produce
more than the normal results from a given course of action
Leverage refers to the relationship between two variables.
In financial analysis it measures the responsiveness or
influence of one financial variable over the other financial
variable.
Leverage involves using fixed costs to magnify the
potential return to a firm

Can produce beneficial results in favorable conditions

Can produce highly negative results in unfavorable conditions
 Leverage in a Business
Determining type of fixed operational costs
Plant and equipment
 Can reduce expensive labor in production of inventory
Expensive labor
 Lessens opportunity for profit but reduces risk exposure
Determining type of fixed financial costs
Debt financing
 Can produce substantial profits, but failure to meet contractual obligations
can result in bankruptcy
Selling equity
 May reduce potential profits for existing shareholders, but reduces their
risk exposure
Break-Even (BE) Point
Quantity where Total Revenue equals Total
Cost
Company has no Profit or Loss
BE = FC / (P – VC)
A leveraged firm has a high BE point
A non-leveraged firm has a low BE point
FIGURE 5-1
Break-even chart:
Leveraged firm
FIGURE 5-2
Break-even chart:
Conservative firm
TABLE 5-2
Volume-cost-profit analysis:
Leveraged firm
TABLE 5-3
Volume-cost-profit analysis:
Conservative firm
FIGURE 5-3
Nonlinear break-even
analysis
Operating Leverage (Leverage of first order or
first stage leverage)
Measure of the amount of fixed operating costs used
by a firm.
Degree of Operating Leverage (DOL) = % in EBIT
(or Operating Income) / %  in Sales

DOL = Q(P-VC) / (Q(P-VC) –FC)= Cont/EBIT

=> % change in EBIT = % change in sales x DOL

Operating Leverage measures the sensitivity of a

firm’s operating income to a  in sales.
Important points related to DOL
It is the % change in EBIT due to 1% change in sales.
It arises as a result of presence of fixed operating costs in the cost
structure.
In the absence of fixed operating costs the % change in EBIT will be
equal to % change in sales that is there is no operating leverage to
magnify the impact of change in sales on change in EBIT.

A positive DOL means that the firm is operating above breakeven level

A negaive DOL means that the firm is operating below breakeven level
A high DOL represents a high risk and even a small decrease in sales
can severely affect the firm’s efforts to earn profits.
Question
 ABC Ltd. Sells 1000 units at Rs.10/unit.

Case I - The cost of production consists of only variable cost

which is
Rs.7/unit.
Case II - The cost of production consists of fixed costs of
Rs.1000 and
a variable component of Rs.7/unit.

The firm is able to increase its sales to 1400 units. Calculate the
DOL.
TABLE 5-4
Operating income or
loss
Financial Leverage (Leverage of second order
or second stage leverage)
Measure of the amount of debt used by a firm
Degree of Financial Leverage (DFL) = % in
EPS / %  in EBIT (or Operating Income)
DFL = EBIT / (EBIT –I)
DFL = EBIT/EBT
 DFL = EBIT / [EBT – PD/(1-T)] Incase the firm
has preference share capital in its capital structure
Financial Leverage measures the sensitivity of a
firm’s earnings per share to a  in operating
income
Question
 ABC Ltd. Sells 1000 units at Rs.10/unit.

Case I - The cost of production consists of only variable cost

which is
Rs.7/unit.
Case II - The cost of production consists of fixed costs of Rs.1000
and
a variable component of Rs.7/unit.

The firm is able to increase its sales to 1400 units. Calculate the DFL
if the firm has raised a capital of Rs.5000 financed by:
Case I – 500 equity shares of Rs.10 each
Case II – Rs.2000 by issue of 10% debentures and rest by equity
shares of Rs.10 each.
Important points related to DFL
It is the % change in EPS due to 1% change in EBIT.
It arises as a result of presence of fixed Financial costs like interest
and preference dividend.
In the absence of fixed financial costs the % change in EPS will be
equal to % change in EBIT that is there is no Financial leverage to
magnify the impact of change in EBIT on change in EPS.

A positive DFL means that the firm is operating above financial

breakeven level
A negative DFL means that the firm is operating below financial
breakeven level
A high DFL represents a high risk and even a small decrease in
EBIT can severely affect the firm’s efforts to earn for its
shareholders.
Leverage Means Risk

Leverage is a double-edged sword

It magnifies profits as well as losses
An aggressive or highly leveraged firm has high
fixed costs (and a relatively high break-even point)
A conservative or non-leveraged firm has low fixed
costs (and a relatively low break-even point)
FIGURE 5-4
Financing plans and
earnings per share
TABLE 5-5
Impact of financing
plan on earnings
per share
Financial Leverage
Reflects the amount of debt used in the capital
structure of the firm
Determines how the operation is to be financed
Determines the performance between two firms having
equal operating capabilities

BALANCE SHEET
Assets Liabilities and Net Worth
Operating leverage Financial leverage
TABLE 5-6
Income statement
Combined or Total Leverage

Represents maximum use of leverage

Degree of Combined or Total Leverage
(DCL or DTL) = % in EPS / % in
Sales
DCL= Q(P-VC)/(Q(P-VC)-FC-I)
= (S-TVC) /( S-TVC –FC- I)
Short-cut formula:
DCL or DTL = DOL x DFL
TABLE 5-7
Operating and
financial leverage
Combining Operating
and Financial Leverage
Combined leverage: when both leverages allow a firm
to maximize returns
Operating leverage:
 Affects the asset structure of the firm
 Determines the return from operations
Financial leverage:
 Affects the debt-equity mix
 Determines how the benefits received will be allocated