Leverage

INTRODUCTION
Financial decision is one of the integral and important parts of financial management in
any kind of business concern. A sound financial decision must consider the board coverage
of the financial mix (Capital Structure), total amount of capital (capitalization) and cost of
capital (Ko). Capital structure is one of the significant things for the management, since it
influences the debt equity mix of the business concern, which affects the shareholder’s
return and risk. Hence, deciding the debt-equity mix plays a major role in the part of the
value of the company and market value of the shares. The debt equity mix of the company
can be examined with the help of leverage.
The concept of leverage is discussed in this part. Types and effects of leverage is
discussed in the part of EBIT and EPS.
Meaning of Leverage
The term leverage refers to an increased means of accomplishing some purpose. Leverage
is used to lifting heavy objects, which may not be otherwise possible. In the financial point
of view, leverage refers to furnish the ability to use fixed cost assets or funds to increase
the return to its shareholders.

Definition of Leverage
James Horne has defined leverage as, “the employment of an asset or fund for which the
firm pays a fixed cost or fixed return.

Types of Leverage
Leverage can be classified into three major headings according to the nature of the finance
mix of the company.
 Leverage 84

Leverage

Finacial Leverage Operating Leverage

Composite Leverage

Fig. 7.1 Types of Leverage

The company may use finance or leverage or operating leverage, to increase the EBIT
and EPS.

OPERATING LEVERAGE
The leverage associated with investment activities is called as operating leverage. It is
caused due to fixed operating expenses in the company. Operating leverage may be defined
as the company’s ability to use fixed operating costs to magnify the effects of changes in
sales on its earnings before interest and taxes. Operating leverage consists of two important
costs viz., fixed cost and variable cost. When the company is said to have a high degree of
operating leverage if it employs a great amount of fixed cost and smaller amount of variable
cost. Thus, the degree of operating leverage depends upon the amount of various cost
structure. Operating leverage can be determined with the help of a break even analysis.
Operating leverage can be calculated with the help of the following formula:
C
OL =
OP
Where,
OL = Operating Leverage
C = Contribution
OP = Operating Profits
Degree of Operating Leverage
The degree of operating leverage may be defined as percentage change in the profits
resulting from a percentage change in the sales. It can be calculated with the help of the
following formula:
Percentage change in
DOL =
profits Percentage change
insales
 Leverage 85
Exercise 1
From the following selected operating data, determine the degree of operating leverage.
Which company has the greater amount of business risk? Why?

Company A Company B
Rs. Rs.
Sales 25,00,000 30,00,000
Fixed costs 7,50,000 15,00,000

Variable expenses as a percentage of sales are 50% for company A and 25% for
company B.
Solution
Statement of Profit
Company A Company B
Rs. Rs.
Sales 25,00,000 30,00,000
Variable cost 12,50,000 7,50,000
Contribution 12,50,000 22,50,000
Fixed cost 7,50,000 15,00,000
Operating Profit 5,00,000 7,50,000

Contribution
Operating Leverage =
Operating Profit

12,50,000
“A” Company Leverage = = 2.5
5,00,000
2,25,000
“B” Company Leverage = =3
7,50,000
Comments
Operating leverage for B Company is higher than that of A Company; B Company has a
higher degree of operating risk. The tendency of operating profit may vary portionately
with sales, is higher for B Company as compared to A Company.

Uses of Operating Leverage

Operating leverage is one of the techniques to measure the impact of changes in sales
which lead for change in the profits of the company.
If any change in the sales, it will lead to corresponding changes in profit.
Operating leverage helps to identify the position of fixed cost and variable cost.
 Leverage 86
Operating leverage measures the relationship between the sales and revenue of the
company during a particular period.
Operating leverage helps to understand the level of fixed cost which is invested in the
operating expenses of business activities.
Operating leverage describes the over all position of the fixed operating cost.

FINANCIAL LEVERAGE
Leverage activities with financing activities is called financial leverage. Financial leverage
represents the relationship between the company’s earnings before interest and taxes
(EBIT) or operating profit and the earning available to equity shareholders.
Financial leverage is defined as “the ability of a firm to use fixed financial charges to
magnify the effects of changes in EBIT on the earnings per share”. It involves the use of
funds obtained at a fixed cost in the hope of increasing the return to the shareholders.
“The use of long-term fixed interest bearing debt and preference share capital along with
share capital is called financial leverage or trading on equity”.
Financial leverage may be favourable or unfavourable depends upon the use of fixed
cost funds.
Favourable financial leverage occurs when the company earns more on the assets
purchased with the funds, then the fixed cost of their use. Hence, it is also called as positive
financial leverage.
Unfavourable financial leverage occurs when the company does not earn as much as
the funds cost. Hence, it is also called as negative financial leverage.
Financial leverage can be calculated with the help of the following formula:

OP
FL = PBT
Where,
FL = Financial leverage
OP = Operating profit
(EBIT) PBT = Profit before
tax.
Degree of Financial Leverage
Degree of financial leverage may be defined as the percentage change in taxable profit as a
result of percentage change in earning before interest and tax (EBIT). This can be calculated
by the following formula

Percentage change in taxable Income

DFL=
Precentage change in EBIT
 Leverage 87
Alternative Definition of Financial Leverage
According to Gitmar, “financial leverage is the ability of a firm to use fixed financial changes
to magnify the effects of change in EBIT and EPS”.

EBIT
FL = EPS
Where,
FL = Financial Leverage
EBIT = Earning Before Interest and
Tax EPS = Earning Per share.
Exercise 2
A Company has the following capital structure.

Rs.
Equity share capital 1,00,000
10% Prof. share capital 1,00,000
8% Debentures 1,25,000

The present EBIT is Rs. 50,000. Calculate the financial leverage assuring that the
company is in 50% tax bracket.
Solution

Statement of Profit Rs.

Earning Before Interest and Tax (EBIT) 50,000
(or) Operating Profit
. Interest on Debenture
1,25,000 × 8 × 100
Earning before Tax (EBT) 10,000
40,000
Income Tax 20,000
Profit
20,000

Operating Profit (OP)

Financial leverage =
Profit BeforeTax (PBT)
50,000
= =1.25
40,000

Uses of Financial Leverage

Financial leverage helps to examine the relationship between EBIT and EPS.
 Financial leverage measures the percentage of change in taxable income to the percentage
change in EBIT.
Financial leverage locates the correct profitable financial decision regarding capital structure
Leverage 88
of the company.
Financial leverage is one of the important devices which is used to measure the fixed cost
proportion with the total capital of the company.
If the firm acquires fixed cost funds at a higher cost, then the earnings from those
assets, the earning per share and return on equity capital will decrease.
The impact of financial leverage can be understood with the help of the following exercise.
Exercise 3
XYZ Ltd. decides to use two financial plans and they need Rs. 50,000 for total investment.

Particulars Plan A Plan B

Debenture (interest at 10%) 40,000 10,000
Equity share (Rs. 10 each) 10,000 40,000
Total investment needed 50,000 50,000
Number of equity shares 4,000 1,000

The earnings before interest and tax are assumed at Rs. 5,000, and 12,500. The tax rate is
50%. Calculate the EPS.
DISTINGUISH BETWEEN OPERATING LEVERAGE AND FINANCIAL LEVERAGE
Operating Leverage/Financial Leverage
Operating Leverage Financial Leverage
1. Operating leverage is associated with 1. Financial leverage is associated with financing
investment activities of the company. activities of the company.
2. Operating leverage consists of fixed 2. Financial leverage consists of operating profit of
operating expenses of the company. the company.
3. It represents the ability to use fixed 3. It represents the relationship between EBIT and
operating cost. EPS.
4. Operating leverage can be calculated by 4. Financial leverage can be calculated by
C OP
OL = . FL = .
OP PBT
5. A percentage change in the profits resulting 5. A percentage change in taxable profit is the
from a percentage change in the sales is called as result of percentage change in EBIT.
degree of operating leverage.
6. Trading on equity is not possible while the 6. Trading on equity is possible only when the
company is operating leverage. company uses financial leverage.
7. Operating leverage depends upon fixed cost 7. Financial leverage depends upon the
and variable cost. operating profits.
8. Tax rate and interest rate will not affect the 8. Financial leverage will change due to tax rate and
operating leverage. interest rate.