CHAPTER a

6
FINANCING
DECISIONS-
LEVERAGES
LEARNING OUTCOMES
After studying this chapter, you would be able to -
 Understand the concept of business risk and financial risk.
 Discuss and interpret the types of leverages.
 Discuss the relationship between operating leverage, Break -
even analysis & Margin of Safety.
 Discuss positive and negative Leverage.
 Discuss Financial leverage as ‘Trading on equity’.
 Discuss Financial Leverage as ‘Double Edged Sword’.

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 6.2 FINANCIAL MANAGEMENT
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CHAPTER OVERVIEW

Analysis of Leverage

Types of Leverage
Business and
Financial Risk (i) Operating Leverage
(ii) Financial Leverage
(iii) Combined Leverage

1. INTRODUCTION
Objective of financial management is to maximize wealth. Here, wealth means
market value. Value is directly related to performance of company and inversely
related to expectation of investors. In turn, expectation of investor is dependent
on risk of the company. Therefore, to maximize value, company should try to
manage its risk. This risk may be business risk, financial risk or both as defined
below:
Business Risk: It refers to the risk associated with the firm's operations. It is the
uncertainty about the future operating income (EBIT) i.e., how well can the
operating income be predicted?
Financial Risk: It refers to the additional risk placed on the firm's shareholders
because of use of debt i.e., the additional risk, a shareholder bears when a
company uses debt in addition to equity financing. Companies that issue more
debt instruments would have higher financial risk than companies financed
mostly or entirely by equity.
In this chapter we will discuss factors that influence business and financial risks.

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 FINANCING DECISIONS - LEVERAGES 6.3 6.3

2. MEANING AND TYPES OF LEVERAGE

2.1 Meaning of Leverage
The term leverage represents influence or power. In financial analysis, leverage
represents the influence of one financial variable over some other related
financial variable. These financial variables may be costs, output, sales revenue,
Earnings Before Interest and Tax (EBIT), Earning Per Share (EPS) etc.
Generally, if we want to calculate the impact of change in variable X on variable Y,
it is termed as Leverage of Y with X, and it is calculated as follows:

Change in Y÷Y
Measurement of Leverage=
Change in X ÷X

2.2 Types of Leverage

There are three commonly used measures of leverage in financial analysis. These are:
(i) Operating Leverage: It is the relationship between Sales and EBIT and
indicates business risk.

Operating Leverage Business risk

(ii) Financial Leverage: It is the relationship between EBIT and EPS and indicates
financial risk.

Financial Leverage Financial risk

(iii) Combined Leverage: It is the relationship between Sales and EPS and
indicates total risk i.e., both business risk and financial risk.

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 6.4 FINANCIAL MANAGEMENT
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Combined Leverage Total risk

2.3 Chart Showing Degree of Operating Leverage,

Financial Leverage and Combined leverage
Profitability Statement

Sales xxx

Less: Variable Cost (xxx)

Contribution xxx Degree of Operating

Less: Fixed Cost (xxx) Leverage

Operating Profit/ EBIT xxx

Less: Interest (xxx)

Earnings Before Tax (EBT) xxx Degree of

Less: Tax (xxx) Combined

Profit After Tax (PAT) xxx Degree of Financial Leverage

Less: Pref. Dividend (if any) (xxx) Leverage

Net Earnings available to xxx

equity shareholders/ PAT

No. Equity shares (N) xxx

Earnings per Share (EPS) xxx

(PAT ÷ N)

3. OPERATING LEVERAGE

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 FINANCING DECISIONS - LEVERAGES 6.5 6.5

Operating Leverage (OL) means tendency of operating income (EBIT) to change

disproportionately with change in sale volume. This disproportionate change is
caused by operating fixed cost, which does not change with change in sales
volume.

In other words, Operating Leverage maybe defined as the employment of an

asset with a fixed cost so that enough revenue can be generated to cover all the
fixed and variable costs.

The use of assets for which a company pays a fixed cost is called operating
leverage.

Operating leverage is a function of three factors:

(i) Amount of fixed cost,

(ii) Variable contribution margin, and
(iii) Volume of sales.

3.1 Degree of Operating Leverage (DOL)

When we measure magnitude of disproportionate change, it is termed as degree of
leverage. Degree of Operating Leverage (DOL) may be defined as percentage
change in EBIT with respect to percentage change in sales quantity.

Percentage Change in EBIT

Degree of Operating Leverage (DOL) =
Percentage Change in Sales

Mathematically:

∆EBIT ∆Q
DOL =
EBIT Q

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 6.6 FINANCIAL MANAGEMENT
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Here,

EBIT = Q (S – V) – F

Q = Sales quantity

S = Selling price per unit

V = Variable cost per unit

 Denotes change

 [Q (S-V)-F] / [Q (S-V)-F]
DOL =
Q / Q

Now F is nil because change in fixed cost is nil. Therefore:

 Q (S-V) Q  Q (S-V) Q Q (S-V)

DOL = = × =
Q (S-V)-F Q Q (S-V)-F  Q Q (S-V)-F

Contribution Contribution
DOL = =
Contribution - Fixed Cost EBIT

3.2 Break-Even Analysis and Operating Leverage

Break-even analysis is a generally used to study the Cost Volume Profit analysis. It
is concerned with computing the break-even point. At break-even point (BEP) of
production level and sales, there will be no profit and loss i.e. total cost is equal
to total sales revenue.

Fixed Cost
Break-even point in units =
Contribution per unit

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 FINANCING DECISIONS - LEVERAGES 6.7 6.7

Let us understand through the following example:

Example - 1:

Particulars Product X Product Y

(`) (`)

Selling Price p.u. 40 20

Variable Cost p.u. 20 12

Contribution p.u. 20 8

Total Contribution of 1,000 units 20,000 8,000

Fixed Cost 15,000 5,000

Profit (EBIT) 5,000 3,000

Break- even point (Fixed Cost / 15,000 5,000

= 750 units = 625 units
Contribution 20 8

Operating Leverage 20,000 8,000

=4 = 2.67
 Contribution  5,000 3,000
 
 EBIT 

There is a relationship between leverage and Break-even point. Both are used for
profit planning.
In brief, the relationship between leverage, break-even point and fixed cost is as
under:

Leverage Break-even point

1. Firm with high leverage 1. Higher Break-even point

2. Firm with low leverage 2 .Lower Break-even point

Fixed cost Operating Leverage

1. High fixed cost 1. High degree of operating leverage

2. Lower fixed cost 2. Lower degree of operating leverage

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 6.8 FINANCIAL MANAGEMENT
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3.3 Margin of Safety (MOS) and Operating Leverage (OL)

In cost accounting, margin of safety (MOS) may be calculated as follows:

Sales - BEP Sales

MOS = × 100
Sales

Higher margin of safety indicates lower business risk and higher profit and vice
versa. MOS is inversely related to OL.

If we both multiply and divide above formula with profit volume (PV) ratio then:

Sales - BEP Sales PV Ratio (Sales × PV Ratio)- (BEP × PV Ratio)

MOS = × =
Sales PV Ratio Sales × PV Ratio

We knows that:
Contribution
PV ratio = or Sales × PV ratio = Contribution
Sales
And,
Fixed Cost
BEP = or BEP × PV ratio = Fixed Cost
PV ratio

So,
Contribution - Fixed Cost EBIT
MOS = =
Contribution Contribution

Further,
Contribution
DOL =
EBIT
hence:

1
Degree of Operating leverage =
Margin of Safety

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 FINANCING DECISIONS - LEVERAGES 6.9 6.9

Let us understand this through the following example:

Example – 2:

Particulars Product X
(`)
Sales (50 x 1000 units) 50,000
Variable Cost (30 x 1000 units) 30,000
Contribution 20,000
Fixed Cost 15,000
Profit (EBIT) 5,000
Break- even Sales (Fixed Cost / PV ratio) 15,000/0.40 = 37,500
Margin of Safety = (50,000-37,500)/50,000 0.25
Operating Leverage = Contribution/EBIT = 4
20,000/5,000
Operating Leverage = 1/MOS = 1/0.25 4

If Margin of safety Business Risk DOL (1/MOS)

Rises Falls Falls
Falls Rises Rises

When DOL is more than one (1), operating leverage exists. More is the DOL,
higher is operating leverage.
A positive DOL/ OL means that the firm is operating at higher level than the break- even
level and both sales and EBIT moves in the same direction. In case of negative DOL/ OL,
firm operates at lower than the break-even sales and EBIT is negative.
Situation 1: No Fixed Cost

Particulars 20,000 units 30,000 units

(`) (`)
Sales @ ` 10 2,00,000 3,00,000
Variable cost @ ` 5 1,00,000 1,50,000
EBIT 1,00,000 1,50,000

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 6.10 FINANCIAL MANAGEMENT
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Percentage change in EBIT 50%

Degree of Operative leverage (DOL) = = =1
Percentage change in Sales 50%

Situation 2: Positive Leverage

Particulars 20,000 units 30,000 units

(`) (`)
Sales @ ` 10 2,00,000 3,00,000

Variable Cost @ ` 5 1,00,000 1,50,000

Contribution 1,00,000 1,50,000

Fixed Cost 50,000 50,000

EBIT 50,000 1,00,000

Percentage change in EBIT 100%

Degree of Operative leverage (DOL) = = =2
Percentage change in sales 50%

Situation 3: When EBIT is Nil (Contribution = Fixed cost)

Contribution
Degree of Operating Leverage (DOL) = = Undefined
0

Analysis and Interpretation of operating leverage

S. No. Situation Result

1 No Fixed Cost No operating leverage

2. Higher Fixed cost Higher Break-even point

3. Higher than Break-even level Positive operating leverage

4. Lower than Break-even level Negative operating leverage

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 FINANCING DECISIONS - LEVERAGES 6.116.11

Operating Leverage
and EBIT

Infinite/
Negative Positive
Undefined

Operating at a Higher
Operating at Lower Operating at break-
Level than break-even
than break-even point even point
point

EBIT= -Ve EBIT = 0 EBIT = +Ve

Positive and Negative Operating Leverage

Note: DOL can never be between zero and one. It can be zero or less or it can be
one or more.

DOL
positive

1
BEP
0
Sale
s
negative

When Sales is much higher than BEP sales, DOL will be slightly more than one.
With decrease in sales, DOL will increase. At BEP, DOL will be infinite. When sales
is slightly less than BEP, DOL will be negative infinite. With further reduction in
sale, DOL will move towards zero. At zero sales, DOL will also be zero.

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 6.12 FINANCIAL MANAGEMENT
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ILLUSTRATION 1
A Company produces and sells 10,000 shirts. The selling price per shirt is ` 500.
Variable cost is ` 200 per shirt and fixed operating cost is ` 25,00,000.
(a) CALCULATE operating leverage.
(b) If sales are up by 10%, then COMPUTE the impact on EBIT?
SOLUTION
(a) Statement of Profitability

`
Sales Revenue (10,000 × 500) 50,00,000

Less: Variable Cost (10,000 × 200) 20,00,000

Contribution 30,00,000

Less: Fixed Cost 25,00,000

EBIT 5,00,000

Contribution ` 30 lakhs
Operating Leverage = = = 6 times
EBIT ` 5 lakhs

%Change in EBIT
(b) Operating Leverage (OL) =
%Change in Sales

X / 5,00,000
6 =
5,00,000 50,00,000

X = ` 3,00,000

EBIT = ` 3,00,000/` 5,00,000 = 60%

ILLUSTRATION 2
CALCULATE the operating leverage for each of the four firms A, B, C and D from the
following price and cost data:

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 FINANCING DECISIONS - LEVERAGES 6.136.13

Firms

A (`) B(`) C(`) D(`)

Sale price per unit 20 32 50 70

Variable cost per unit 6 16 20 50
Fixed operating cost 60,000 40,000 1,00,000 Nil

What calculations can you draw with respect to levels of fixed cost and the degree of
operating leverage result? EXPLAIN. Assume number of units sold is 5,000.
SOLUTION

Firms

A (`) B (`) C (`) D (`)

Sales (units) 5,000 5,000 5,000 5,000

Sales revenue 1,00,000 1,60,000 2,50,000 3,50,000

(Units × sale price per unit)

Less: Variable cost (30,000) (80,000) (1,00,000) (2,50,000)

(Units × variable cost per unit)

Less: Fixed operating costs (60,000) (40,000) (1,00,000) Nil

EBIT 10,000 40,000 50,000 1,00,000

Current sales (S) - Variable costs (VC)

DOL =
Current EBIT
` 1,00,000  ` 30,000
DOL(A)  =7
` 10,000
`1,60,000  ` 80,000
DOL(B) = =2
` 40,000
` 2,50,000  ` 1,00,000
DOL(C) = =3
` 50,000
`3,50,000  ` 2,50,000
DOL(D) = =1
` 1,00,000

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 6.14 FINANCIAL MANAGEMENT
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The operating leverage exists only when there are fixed costs. In the case of firm
D, there is no magnified effect on the EBIT due to change in sales. A 20 per cent
increase in sales has resulted in a 20 per cent increase in EBIT. In the case of other
firms, operating leverage exists. It is maximum in firm A, followed by firm C and
minimum in firm B. The interception of DOL of 7 is that 1 per cent change in sales
results in 7 per cent change in EBIT level in the direction of the change of sales
level of firm A.

4. FINANCIAL LEVERAGE
Financial leverage (FL) maybe defined as ‘the use of funds with a fixed cost in
order to increase earnings per share’. In other words, it is the use of company
funds on which it pays a limited return. Financial leverage involves the use of
funds obtained at a fixed cost in the hope of increasing the return to common
stockholders.
Earnings before interest and tax(EBIT)
Financial Leverage (FL) =
Earnings before tax(EBT)

Where, EBIT = Sales - (Variable cost + Fixed cost)

EBT = EBIT - Interest

4.1 Degree of Financial Leverage (DFL)

Degree of financial leverage is the ratio of the percentage increase in Earnings Per
Share (EPS) to the percentage increase in Earnings Before Interest and Taxes
(EBIT). Financial Leverage (FL) is also defined as “the ability of a firm to use
fixed financial charges to magnify the effect of changes in EBIT on EPS

Degree of Financial Leverage (DFL)

Percentage change in earnings per share (EPS)
=
Percentage change in earnigs before interest and tax (EBIT)

∆EPS ∆EBIT
DFL =
EPS EBIT
ΔEPS means change in EPS and ΔEBIT means change in EBIT.

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 FINANCING DECISIONS - LEVERAGES 6.156.15

Now, EPS = [(EBIT - I)(1- t)] - D/No. of Shares

Here,
T = Tax Rate
D = Dividend on Preference Shares (inclusive of dividend tax if any)
On simplifying the above we get,
EBIT(1-t)
DFL =
(EBIT-Int.)(1-t) - DP
EBIT
DFL= DP
(EBIT-Int.)-
1-t
If the company has not issued preference shares, then:
EBIT EBIT
DFL = =
EBIT-Int. PBT
When DFL is more than one (1), financial leverage exists. More is DFL, higher is
financial leverage.

A positive DFL/ FL means firm is operating at a level higher than break-even point
and EBIT and EPS moves in the same direction. Negative DFL/ FL indicates the
firm is operating at lower than break-even point and EPS is negative.
Let us understand through the following analysis:
Situation 1: No Fixed Interest charges

Particulars X Y
(`) (`)
EBIT 1,00,000 1,50,000
Tax @ 50% 50,000 75,000
PAT 50,000 75,000
No. of shares 10,000 10,000
EPS 5 7.5

Change in EP 50%
Degree of Finance Leverage (DFL) = = =1
Change in EBIT 50%

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 6.16 FINANCIAL MANAGEMENT
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Situation 2: Positive Financial Leverage

Particulars X Y
(`) (`)
EBIT 1,00,000 1,50,000
Interest 20,000 20,000
EBT 80,000 1,30,000
Tax @ 50% 40,000 65,000
PAT 40,000 65,000
No of Shares 10,000 10,000
EPS 4 6.5
*
Change in EPS 62.5%
Degree of Finance Leverage (DFL)= = = 1.25
Change in EBIT 50%

 2.5 
 ×100 
*Change in EPS =
 4  = 62.5%
50%
Situation 3. When EBT is nil (EBIT = Fixed Interest)
EBIT
Degree of Finance Leverage (DFL) = = Undefined
Nil

Financial Leverage

Positive Infinite/ Negative

Undefined

EBIT level is EBIT level is less

more than Fixed Operating at than Fixed
Financial Charge Financial break Financial Charge
even point

EPS: will change in

the same direction No Profit no EPS : Negative
as EBIT Loss

Positive and Negative Financial Leverage

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 FINANCING DECISIONS - LEVERAGES 6.176.17

Analysis and Interpretation of Financial leverage

Sl. No. Situation Result

1 No Fixed Financial Cost No Financial leverage

2. Higher Fixed Financial cost Higher Financial Leverage

3. When EBIT is higher than Financial Break-even Positive Financial leverage

point

4. When EBIT is less then Finance Break-even Negative Financial leverage

point

4.2 Financial Leverage as ‘Trading on Equity’

Financial leverage indicates the use of funds with fixed cost like long term debts
and preference share capital along with equity share capital which is known as
trading on equity. The basic aim of financial leverage is to increase the earnings
available to equity shareholders using fixed cost fund.
A firm is known to have a positive/favourable leverage when its earnings are more
than the cost of debt. If earnings are equal to or less than cost of debt, it will be
an negative/unfavourable leverage. When the quantity of fixed cost fund is
relatively high in comparison to equity capital it is said that the firm is ‘’trading
on equity”.

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 6.18 FINANCIAL MANAGEMENT
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4.3 Financial Leverage as a ‘Double edged Sword’

When the cost of ‘fixed cost fund’ is less than the return on investment, financial
leverage will help to increase return on equity and EPS. The firm will also benefit
from the saving of tax on interest on debts etc. However, when cost of debt will
be more than the return it will affect return of equity and EPS unfavourably and as
a result firm can be under financial distress. Therefore, financial leverage is also
known as “double edged sword”.
Effect on EPS and ROE:
When, ROI > Interest – Favourable – Advantage

When, ROI < Interest – Unfavourable – Disadvantage

When, ROI = Interest – Neutral – Neither advantage nor disadvantage

Note: DFL can never be between zero and one. It can be zero or less or it can be
one or more.

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 FINANCING DECISIONS - LEVERAGES 6.196.19

DFL
positive

1
Financial BEP*
0
EBIT

negative

*Financial BEP is the level of EBIT at which earning per share is zero. If a company
has not issued preference shares, then Financial BEP is simply equal to amount of
Interest.
When EBIT is much higher than Financial BEP, DFL will be slightly more than one.
With decrease in EBIT, DFL will increase. At Financial BEP, DFL will be infinite.
When EBIT is slightly less than Financial BEP, DFL will be negative infinite. With
further reduction in EBIT, DFL will move towards zero. At zero EBIT, DFL will also
be zero.

5. COMBINED LEVERAGE
Combined leverage may be defined as the potential use of fixed costs, both
operating and financial, which magnifies the effect of sales volume change on
the earning per share of the firm.
Combined Leverage (CL) = Operating Leverage (OL) × Financial Leverage (FL)
C EBIT
= ×
EBIT EBT
C
=
EBT

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 6.20 FINANCIAL MANAGEMENT
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5.1 Degree of Combined Leverage (DCL)

Degree of combined leverage (DCL) is the ratio of percentage change in earning
per share to the percentage change in sales. It indicates the effect the changes
in sales will have on EPS.
DCL = DOL × DFL
%Changein EBIT %Change in EPS
= ×
%Changein Sales %Change in EBIT
%Changein EPS
=
%Changein Sales

Like operating leverage and financial leverage, combined leverage can also be
positive and negative combined leverage.

5.2 Analysis of Combined Leverage

Combine leverage measures total risk. It depends on combination of operating
and financial risk.

DOL DFL Comments

Low Low Lower total risk.

Cannot take advantage of trading on equity.

High High Higher total risk. Very risky combination.

High Low Moderate total risk. Not a good combination.

Lower EBIT due to higher DOL and lower advantage of trading on
equity due to low DFL.

Low High Moderate total risk. Best combination.

Higher financial risk is balanced by lower total business risk.

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 FINANCING DECISIONS - LEVERAGES 6.216.21

ILLUSTRATION 3
A firm’s details are as under:

Sales (@100 per unit) ` 24,00,000

Variable Cost 50%
Fixed Cost ` 10,00,000
It has borrowed ` 10,00,000 @ 10% p.a. and its equity share capital is ` 10,00,000
(` 100 each).
Consider tax @ 50 %.
CALCULATE:
(a) Operating Leverage
(b) Financial Leverage
(c) Combined Leverage
(d) Return on Investment
(e) If the sales increases by ` 6,00,000; what will the new EBIT?
SOLUTION

(`)
Sales 24,00,000
Less: Variable cost 12,00,000
Contribution 12,00,000
Less: Fixed cost 10,00,000
EBIT 2,00,000
Less: Interest 1,00,000
EBT 1,00,000
Less: Tax (50%) 50,000
EAT 50,000
No. of equity shares 10,000

EPS 5

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 6.22 FINANCIAL MANAGEMENT
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`12,00,000
(a) Operating Leverage   6 times
`2,00,000
`2,00,000
(b) Financial Leverage   2 times
`1,00,000

(c) Combined Leverage = OL × FL = 6 × 2 = 12 times.

`50,000
(d) ROI   100  5%
`10,00,000
EAT-Pref.Dividend
Here ROI is calculated as ROE i.e.
Equity shareholders'fund

(e) Operating Leverage = 6

Δ EBIT
6=
0.25
6 1
Δ EBIT   1.5
4
Increase in EBIT = ` 2,00,000 × 1.5
= ` 3,00,000

New EBIT = ` 5,00,000

ILLUSTRATION 4
The following information is related to Yizi Company Ltd. for the current Financial
Year:

Equity share capital (of ` 10 each) ` 50 lakhs

12% Bonds of ` 1,000 each ` 37 lakhs

Sales ` 84 lakhs

Fixed cost (excluding interest) ` 6.96 lakhs

Financial leverage 1.49

Profit-volume Ratio 27.55%

Income Tax Applicable 40%

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 FINANCING DECISIONS - LEVERAGES 6.236.23

You are required to CALCULATE:

(i) Operating Leverage;
(ii) Combined leverage; and
(iii) Earnings per share.
Show calculations up-to two decimal points.
SOLUTION
Computation of Profits after Tax (PAT)

Particulars (`)
Sales 84,00,000
Contribution (Sales × P/V ratio) 23,14,200
Less: Fixed cost (excluding Interest) (6,96,000)
EBIT (Earnings before interest and tax) 16,18,200
Less: Interest on debentures (12%  `37 lakhs) (4,44,000)
Less: Other fixed Interest (balancing figure) (88,160)*
EBT (Earnings before tax) 10,86,040
Less: Tax @ 40% 4,34,416
PAT (Profit after tax) 6,51,624

(i) Operating Leverage:

Contribution ` 23,14,200
= = = 1.43
EBIT ` 16,18,200

(ii) Combined Leverage:

= Operating Leverage × Financial Leverage
= 1.43  1.49 = 2.13
Or,
Contribution EBIT
Combined Leverage = ×
EBIT EBT
Contribution ` 23,14,200
Combined Leverage = = = 2.13
EBT ` 10,86,040

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 6.24 FINANCIAL MANAGEMENT
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*
EBIT ` 16,18,200
Financial Leverage = = = 1.49
EBT EBT
` 16,18,200
So, EBT = = `10,86,040
1.49
Accordingly, other fixed interest = ` 16,18,200 - ` 10,86,040 - ` 4,44,000
= ` 88,160
(iii) Earnings per share (EPS):

PAT ` 6,51,624
= = = ` 1.30
No. of shares outstanding 5,00,000 equity shares

ILLUSTRATION 5
Following are the selected financial information of A Ltd. and B Ltd. for the
current Financial Year:

A Ltd. B Ltd.

Variable Cost Ratio 60% 50%

Interest ` 20,000 ` 1,00,000

Operating Leverage 5 2

Financial Leverage 3 2

Tax Rate 30% 30%

You are required to FIND out:

(i) EBIT

(ii) Sales
(iii) Fixed Cost
(iv) Identify the company which is better placed with reasons based on leverages.

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 FINANCING DECISIONS - LEVERAGES 6.256.25

SOLUTION
Company A
EBIT
(i) Financial Leverage =
EBT i.e EBIT – Interest
EBIT
So, 3 =
EBIT – ` 20,000
Or, 3 (EBIT – 20,000) = EBIT
Or, 2 EBIT = 60,000
Or, EBIT = 30,000
Contribution Contribution
(ii) Operating Leverage = Or, 5 =
EBIT ` 30,000

Or, Contribution = ` 1, 50,000

contribution ` 1,50,000
Sales = = = ` 3,75,000
P/V Ratio(1 – variable cost ratio) 40%

(iii) Fixed Cost = Contribution – EBIT

= ` 1, 50,000 – 30,000
Or, Fixed cost = ` 1,20,000
Company B
EBIT
(i) Financial Leverage =
EBT i.e EBIT – Interest
EBIT
So, 2 =
EBIT –1,00,000

Or, 2 (EBIT – `1,00,000) = EBIT

Or, 2 EBIT – ` 2,00,000 = EBIT
Or, EBIT = ` 2,00,000
Contribution
(ii) Operating Leverage =
EBIT
Contribution
Or, 2 =
` 2,00,000

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 6.26 FINANCIAL MANAGEMENT
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Or, Contribution = ` 4,00,000

Contribution ` 4,00,000
Sales = = = ` 8,00,000
P/V Ratio (1 - variable cost ratio) 50%
(iii) Fixed Cost = Contribution – EBIT
= ` 4, 00,000 – ` 2,00,000
Or, Fixed cost = ` 2,00,000
Income Statements of Company A and Company B

Company A Company B
(`) (`)
Sales 3,75,000 8,00,000
Less: Variable cost 2,25,000 4,00,000
Contribution 1,50,000 4,00,000
Less: Fixed Cost 1,20,000 2,00,000
Earnings before interest and tax (EBIT) 30,000 2,00,000
Less: Interest 20,000 1,00,000
Earnings before tax (EBT) 10,000 1,00,000
Less: Tax @ 30% 3,000 30,000
Earnings after tax (EAT) 7,000 70,000

Comment based on Leverage

Comment based on leverage – Company B is better than company A of the
following reasons:
 Capacity of Company B to meet interest liability is better than that of
companies A (from EBIT/Interest ratio)

` 30,000 `2,00,000
[A = = 1.5, B = = 2]
` 20,000 `1,00,000

 Company B has the least financial risk as the total risk (business and
financial) of company B is lower (combined leverage of Company A –
15 and Company B- 4)

@The Institute of Chartered Accountants of India