Q.1 A firm has sales of Rs. 20,00,000, variable cost of Rs.

14,00,000 and
fixed costs of Rs. 4,00,000 and debt of Rs. 10,00,000 at 10% rate of
interest. What are the operating, financial and combined leverages? If
the firm wants to double its Earnings before Interest and Tax (EBIT),
how much of a rise in sales would be needed on a percentage basis?

olution:

Q.2 A firm has sales of Rs. 75,00,000, variable cost of Rs. 42,00,000 and
fixed cost of Rs. 6,00,000. It has a debt of Rs. 45,00,000 at 9% and
equity of Rs. 55,00,000.
(i) What is the firm’s ROI?

(ii) Does it have favourable financial leverage?

(iii) If the firm belongs to an industry whose asset turnover is 3, does it have a high
or low asset leverage?

(iv) What are the operating, financial and combined leverages of the firm?

(v) If the sales drop to Rs. 50,00,000, what will be the new EBIT?

(vi) At what level the EBT of the firm will be equal to zero?
Solution:
Operating Leverage vs Financial leverage
(Comparison Table)
Basis for Comparison

between Financial Leverage Operating Leverage Financial Leverage

vs Operating Leverage

Operating leverage can be defined as Financial leverage can be define

1. Meaning firm’s ability to use fixed costs to generate firm’s ability use capital structure

more returns. better returns and to reduce taxe

2. What it’s all about? It’s about the fixed costs of the firm. It’s about the capital structure of

Operating leverage measures the Financial leverage measures the

3. Measurement
operating risk of a business. risk of a business.

Operating leverage can be calculated

Financial leverage can be calcul
4. Calculation when we divide contribution by EBIT of
when we divide EBIT by EBT of
the firm.

5. Impact When degree of operating leverage is When degree of financial levera

higher, it depicts more operating risk for higher, it depicts more financial
 the firm and vice versa. the firm and vice versa.

Financial leverage has a direct

The degree of operating leverage is
6. In relation with relationship with the liability side
usually higher than Break Even Point.
balance sheet.

7. How much it is
The preference is lower. The preference is much higher.
preferred?

Difference Between Operating Leverage and Financial Leverage

July 8, 2015 By Surbhi S Leave a Comment

In
general, leverage means affect of one variable over another. In financial management, leverage
is not much different, it means change in one element, results in change in profit. It implies,
making use of such asset or source of funds like debentures for which the company has to pay
fixed cost or financial charges, to get more return. There are three measures of Leverage i.e.
operating leverage, financial leverage, and combined leverage. The operating
leverage measures the effect of fixed cost whereas the financial leverage evaluates the effect
of interest expenses.

Combined Leverage is the combination of the two leverages. While operating leverage delineates
the effect of change in sales on the company’s operating earning, financial leverage reflects the
change in EBIT on EPS level. Check out the article given below to understand the difference
between operating leverage and financial leverage.
Content: Operating Leverage Vs Financial Leverage

1. Comparison Chart
2. Definition
3. Key Differences
4. Conclusion

Comparison Chart

BASIS FOR
OPERATING LEVERAGE FINANCIAL LEVERAGE
COMPARISON

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

company's operations for which capital structure for which it has
it has to pay fixed costs is known to pay interest expenses is
as Operating Leverage. known as Financial Leverage.

Measures Effect of Fixed operating costs. Effect of Interest expenses

Relates Sales and EBIT EBIT and EPS

Ascertained by Company's Cost Structure Company's Capital Structure

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.

Definition of Operating Leverage

When a firm utilizes fixed cost bearing assets, in its operational activities in order to earn more
revenue to cover its total costs is known as Operating Leverage. The Degree of Operating
Leverage (DOL) is used to measure the effect on Earning before interest and tax (EBIT) due to
the change in Sales.
The firm, which employs high fixed cost and the low variable cost is regarded as high operating
leverage whereas the company which has low fixed cost, and the high variable cost is said to
have less operating leverage. It is fully based on fixed cost. So, the higher the fixed cost of the
company the higher will be the Break Even Point (BEP). In this way, the Margin of Safety and
Profits of the company will be low which reflects that the business risk is higher. Therefore, low
DOL is preferred because it leads to low business risk.

The following formula is used to calculate Degree of Operating Leverage (DOL):

Definition of Financial Leverage

The utilization of such sources of funds which carry fixed financial charges in company’s
financial structure, to earn more return on investment is known as Financial Leverage. The
Degree of Financial Leverage (DFL) is used to measure the effect on Earning Per Share (EPS)
due to the change in firms operating profit i.e. EBIT.

When a company uses debt funds in its capital structure having fixed financial charges in the
form of interest, it is said that the firm employed financial leverage.

The DFL is based on interest and financial charges, if these costs are higher DFL will also be
higher which will ultimately give rise to the financial risk of the company. If Return on Capital
Employed > Return on debt, then the use of debt financing will be justified because, in this case,
the DFL will be considered favorable for the company. As the interest remains constant, a little
increase in the EBIT of the company will lead to a higher increase in the earnings of
the shareholders which is determined by the financial leverage. Hence, high DFL is suitable.

The following formula is used to calculate Degree of Financial Leverage (DFL):

Key Differences Between Operating Leverage and Financial Leverage

The following are the major differences between operating leverage and financial leverage:

1. Employment of fixed cost bearing assets in the company’s operations is known as

Operating Leverage. Employment of fixed financial charges bearing funds in a company’s
capital structure is known as Financial Leverage.
2. The Operating Leverage measures the effect of fixed operating costs, whereas Financial
Leverage measures the effect of interest expenses.
3. Operating Leverage influences Sales and EBIT but Financial Leverage affects EBIT and
EPS.
 4. Operating Leverage arises due to the company’s cost structure. Conversely, the capital
structure of the company is responsible for Financial Leverage.
5. Low operating leverage is preferred because higher DOL will cause high BEP and low
profits. On the other hand, High DFL is best because a slight rise in EBIT will cause a
greater rise in shareholder earnings, only when the ROCE is greater than the after-tax
cost of debt.
6. Operating Leverage creates business risk while Financial Leverage is the reason for
financial risk.

Conclusion

While the performance of financial analysis, Leverage, is used to measure the risk-return
relation for alternative capital structure plans. It magnifies the changes in financial variables
like sales, costs, EBIT, EBT, EPS, etc. The firms which use debt content in its capital structure
are regarded as Levered Firms, but the company with no debt content in its capital structure is
known as Unlevered firms. The multiplication of DOL and DFL will make DCL i.e. Degree of
Combined Leverage.