CA. CS.CMA.

MBA: Naveen Rohatgi

NMIMS School of Law: Finance IV

1.MEANING OF LEVERAGE

Leverage refers to the ability of a firm in employing long term funds having fixed cost to
enhance returns to the owners. In other words, leverage is the employment of fixed assets or
funds for which a firm has to meet fixed costs and fixed obligation irrespective of the level of
activities attained or level of operating profit earned. The higher leverage means higher profit
and vice versa. But a higher leverage implies means outside borrowing is higher and hence
higher risk if the business suddenly dips. But a low leverage does not necessary means a
prudent financial management, as the firm might be incurring an opportunity cost for not
having borrowed funds at a fixed cost to earn higher profits. Leverage are classified into
following types (1) operating leverage (2) Financial leverage (3) combined leverage

Operating Leverage
Definition: Operating Leverage is defined as employment of an asset with a fixed cost
with a hope that sufficient revenue would be generated to be cover all the fixed and variable
cost
When sales changes, Variable Cost will change in proportion to Sales while Fixed Cost
will remain constant. So, a change in Sales will lead to a more than proportional change in
EBIT. The effect of change in sales on EBIT is measured by Operating Leverage.
When Sales increase, Fixed Cost will remain the same irrespective of level of output,
and so, the percentage increase in EBIT will be higher than increase in Sales. This is the
favourable effect of Operating Leverage.
When Sales decreases the reverse process will be applicable and hence, the percentage
decrease in EBIT will be higher than decrease in Sales. This is the adverse effect of
Operating Leverage.
Measurement:
The degree of Operating Leverage (DOL) is measured as under - (expressed in time)
DO M
DOL = (or)
Significance:
Effect on EBIT: DOL measures the impact of change in sales on operating income.
Suppose DOL of a firm is 1.67 times, it implies that 1% change in sales will lead to 1.67%
change in EBIT. Hence, if sales increase by 20%, EBIT increase by 20% x 1.67 = 33%. Also,
if Sales decrease by say 40%, EBIT falls by 40% x 1.67 = 67%.
Impact of Fixed cost: DOL depends on the amount of Fixed Costs. If Fixed Cost are
higher, DOL is higher and vice versa.
Effect of high DOL: If DOL is high, it implies that Fixed Costs are high. Hence the
Break Even Point (BEP) would be reached at a higher level of sales. Due to the high BEP, the

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CA. CS.CMA.MBA: Naveen Rohatgi

NMIMS School of Law: Finance IV

Margin of Safety and profits would be low. This means that the Operating Risks are higher.
Hence, the lower the DOL, the better it is for the business.
Above BEP: A High DOL means that profits (EBIT) may be wiped off, even for a
marginal reduction in Sales. Hence, a Firm should operate sufficiently above the BEP, to
avoid the danger of fluctuations in sales and profits.

Financial Leverage

Meaning: Financial Leverage is defined as the ability of a firm to use fixed financial
charges (interest) to increase EPS.

Explanation:

Financial Leverage occurs when a company has debt content in its capital structure and
fixed financial charges, e.g. interest on debentures. These fixed financial charges do not vary
the EBIT. They are fixed and are to be paid irrespective of level of EBIT.

When EBIT increase, the interest payable on debt remains constant, and hence, Residual
Earning available to Equity Shareholders will also increase more than proportionately.

Hence an increase in EBIT will lead to a higher percentage increase in Earning per Share
(EPS). This is measured by the Financial Leverage.

Measurement:

The degree of Financial Leverage (DFL) is measured as under – (expressed in times)

DFL = (or)

ignificance:

Effect on EPS: DFL measures the impact of change in EBIT (Operating Income) on
EPS. Suppose DFL of a Firm is 4 times, it implies that 1% change in EBIT will lead to 4%
change in EPS, hence, if EBIT increase by 10%, EPS increase by 10% x 4 = 40%. Also, if
EBIT decreases by say 5%, EPS falls by 5% x 4 = 20%.
Impact on Fixed Financial Charges: DFL depends on the magnitude of interest and
fixed financial charges. If these costs are higher, DFL is higher and vice-versa.
Effect on High DFL: If DFL is high, it implies that fixed interest charges are high. This
means that the financial risks are higher. In such a case, the Firm is justified in borrowing /
using Debt Funds, only when it is able to earn at a rate higher than what it has to pay towards
interest on debt.
ROCE vs Interest Rate: DFL is considered to be favourable or advantageous to the
Firm, only if Return on Capital Employed (ROCE) is greater than Rate of Interest on Debt. In

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CA. CS.CMA.MBA: Naveen Rohatgi

NMIMS School of Law: Finance IV

such a case, the use of debt funds is justified, thus magnifying the Residual Earning available
to Equity Shareholders.
NUMERICALS

Q1Annual sales of a company is Rs 60,00,000. Variable costs are 2/3 of sales and Fixed
cost other than interest is Rs 5,00,000 per annum. Company has 11% debentures
of Rs 30,00,000.
You are required to calculate the operating financial and combined leverages of the
company.
Q2 Mahesh has estimated that for a new product its break-even is 2000 units if the
item is sold for Rs 14 per unit: the cost accounting department has currently
identified variable cost Rs 9 per unit. Calculate the degree of operating leverage
for sales volume 2,500 units and 3,000 units.

Q.3 Compute the financial leverage from the following data:

Net worth = Rs 25,00,000
Debt/equity = 3:1
Interest rate = 12 per cent
Operating profit =Rs 20,00,000

Q4 The operating income of Hypothetical Ltd amounts to Rs 1,86,000. It pays 35 per

cent tax on its income. Its capital structure consists of the following:
14% Debentures Rs 5,00,000
15% Preference shares Rs 1,00,000
Equity shares (Rs 100 each) Rs 4,00,000
i. Determine the firm’s EPS. Rs
ii. Determine the percentage change in EPS associated with 30 per cent change (both
increase and decrease) in EBIT.
iii. Determine the degree of financial leverage at the current level of EBIT.
iv. What additional data do you need to compute operating as well as combined
leverage?
Q5 A company operates at a production level of 5000 units. The contribution is Rs 60
per unit, operating leverage is 6, and combined leverage is 24. If tax rate is 30%,
what would be it's earning after tax?

Q6 The Well Established company’s most recent balance sheet is follows:

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CA. CS.CMA.MBA: Naveen Rohatgi

NMIMS School of Law: Finance IV

Liabilities Amount Assets Amount
Rs Rs
Equity capital (Rs 10 per 60,000 Net fixed assets 1,50,000
share) 80,000 Current assets 50,000
10% long- term debt 20,000
Retained earnings 40,000
Current liabilities 2,00,000 Total 2,00,000
Total
The company’s total assets turnover ratio is 3, its fixed operating costs are Rs 1,00,000
and the variable operating costs ratio is 40 per cent. The income tax rate is 35 per cent.
a. Calculate all the three types of leverages.
b. Determine the likely level of EBIT if EPS is (i) Rs 1, (ii) Rs 3, and (iii) Zero

Q7 From the following particulars, prepare income statement of A Ltd. and B. Ltd.
A Ltd. B Ltd.
Degree of Combined Leverage 6 times 15 times
Degree of Operating Leverage 3 times 5 times
Variable Cost as a % of Sales 40% 50%
Rate of Income Tax 35% 35%
Number of Equity Shares 1,00,000 1,00,000
Earnings Per Share 1.30 0.65

Q8) From the following, prepare income statement of A Ltd, B Ltd and C
Ltd.:
Company A B C
Financial leverage 3:1 4:1 2:1
Interest Rs 200 300 1,000
Operating leverage 4:1 5:1 3:1
Variable cost as a percentage of 66:66 75 50
sales
Tax rate (%) 35 35 35

Q9) Calculate operating, financial and combined leverages under

situations when fixed costs are (a) Rs 5,000 (b) Rs 10,000 and financial
plans 1 and 2, from the following information pertaining to the
operation and capital structure of XYZ Ltd.

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CA. CS.CMA.MBA: Naveen Rohatgi

NMIMS School of Law: Finance IV

Total assets Rs 30,000

Total assets turnover based on sales 2
Variable costs as percentage of sales 60%
Capital structure: Financial plans
1 2
Equity Rs 30,000 Rs 10,000
10% Debentures Rs 10,000 Rs 30,000
The capital structure of the progressive corporation Ltd consists of
an ordinary of an ordinary share capital of Rs 10,00,000 (shares of Rs
100 per value) and Rs 10,00,000 of 10% debentures. The unit sales
increased by 20 per cent from 1,00,000 units to 1,20,000 units, the
selling price is Rs 10 per unit, variable costs amount to Rs 6 per unit
and fixed expenses amount to Rs 2,00,000. The income tax rate is
assumed to be 35 per cent.
a. You are required to calculate the following:
i. The percentage increase in earnings per share.
ii. The degree of financial leverage at 1,00,000 units and 1,20,000 units.

Q10) 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
1. What is the firm ROI.
2. Does it have favorable financial leverage.
3. If the firm belongs to an industry whose asset turnover is 3, does it have high or low
asset leverage
4. What are operating, financial and combined leverage of the firm?
5. If sales drop to Rs 50,00,000 what will be the new EBIT?
6. At what level of sales the EBT of the firm will be equal to zero?

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