(Source: Financial management- Principles and Practice by Dr. [Link]; Financial management by Dr. R.P.
Rustagi)
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LEARNING OUTCOME
[Link] Learning Outcome KL PO Level
1. To understand the K2 PO1
concept of leverage.
2. To learn the application of K3 PO2
different types of
leverages.
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INTRODUCTION
• The term leverage, in general, refers to a relationship between two
interrelated variables. With reference to a business firm, these
variables may be costs, output, sales revenue, EBIT, Earnings Per
share (EPS) etc. In financial analysis, the leverage reflects the
responsiveness or influence of one financial variable over some
other financial variable.
• The leverage may be defined as the % change in one variable
divided by the % change in some other variable or
variables. Impliedly, the numerator is the dependent variable, say X,
and the denominator is the independent variable, say Y. The leverage
analysis thus, reflects as to how responsiveness is the dependent
variable to a change in the independent variables.
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TYPES OF LEVERAGE
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OPERATING LEVERAGE
• Firm generally purchases the assets, that its operation will
produce revenue. When sale increases the fixed cost remains
the same and operating revenue will increases. As fixed cost is
constant, the % change in operating revenue is more than %
change in sale. Hence there is a positive relation between
operating leverage and break even point.
Operating leverage= % change in operating profit
% change in sales
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DEGREE OF OPERATING LEVERAGE
• The DOL may, at any particular sales volume, also be calculated as a ratio
of contribution to the EBIT.
Degree of Operating Leverage = Contribution/EBIT
Thus, on the basis of the above analysis, the OL may be interpreted as
follows:
1. The OL is the % change in EBIT as a result of 1% change in sales. OL
arises as a result of fixed cost in the cost structure. If there is no fixed cost,
there will be no OL and the % change in EBIT will be same as % change in
sales.
2. A positive DOL means that the firm is operating at a level higher than the
break-even level and both the EBIT and sales will vary in the same direction.
3. A negative DOL means that the firm is operating at a level lower tan the
break-even level; and the EBIT will be negative.
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SIGNIFICANCE OF OPERATING
LEVERAGE
• Operating Leverage explains the effect of change in sales on
EBIT. When there is high operating leverage, a small rise in
sales will result in a larger rise in EBIT. But if there is small
drop in sales, EBIT will fall dramatically or may even be
wiped off. Thus, existence of high operating leverage reflects
high-risk situation. As the operating leverage reaches its
maximum near break even point, the firm can protect itself
from the dangers of operating leverage and the consequent
operating risk by operating sufficiently above the break even
point.
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FINANCIAL LEVERAGE
• It is also called trading on equity. Financial leverage means the
use of preference share capital, equity share capital along with
fixed interest bearing securities or debentures.
Financial leverage= % change in earning per share
% change in earning before interest and tax
• Financial leverage assumes that the firm is capable of earning
more on assets than that acquired by use of funds, on which
fixed rate of dividend is paid.
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INTERPRETATION OF FINANCIAL
LEVERAGE
• The Financial Leverage is a % change in EPS as result of 1%
change in EBIT. The FL emerges as a result of fixed financial cost
(in the form of interest and preference dividend). If there is no fixed
financial liability, there will be no FL. In such a case the % change
in EPS will be same as % change in EBIT.
• A positive FL means that the firm is operating at a level of EBIT
which is higher than the financial break-even level and both the
EBIT and EPS will vary in the same direction as the EBIT changes.
• A negative FL means that the firm is operating at a level lower than
the financial break-even level and the EPS will be negative.
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COMBINED LEVERAGE
• The Combined Leverage (CL) is not a distinct type of leverage
analysis, rather it is a product of the OL and the FL. The CL may be
defined as the % change in EPS for a given % change in the sales
level and may be calculated as follows:
Combined leverage = % change in earning per share
• % change in sales
or
Combined Leverage = Operating Leverage x Financial Leverage
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INTERPRETATION OF COMBINED
LEVERAGE
• The Combined Leverage is the % change in EPS resulting
from a 1% change in sales level.
• A positive CL means that the leverage is being computed for a
sales level higher than the break even level and both the EPS
and sales will vary in the same direction.
• A negative CL means that the leverage is being calculated for a
sales level lower than the financial break even level and EPS
will be negative.
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FACTORS AFFECTING LEVERAGE OF A
FIRM
• Long Term Debt
• Fixed Assets
• Total Assets
• Market Value of Equity
• Book Value of Equity
• Sales
• Earnings
• Net Capital Employed
• Risks
• Current Assets
• Current Liabilities
• Depreciation
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CONCLUSION
• Leverage focuses on the effect of financing or
debt-equity mix on the shareholder’s earnings and
risk.
• A higher degree of leverage implies that there
would be large change in profits due to a relatively
small change in sales and vice-versa.
• Higher the leverage, higher is the risk and higher is
the expected return.
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