CHAPTER 3: LEVERAGES

1. Introduction

✓ The term leverage represents influence or power.

✓ In financial analysis, leverage represents the influence of one financial variable over some
other related financial variable (Magnifying Effect)
✓ These financial variables may be costs, output, sales revenue, Earnings Before Interest and
Tax (EBIT), Earning Per Share (EPS) etc.
✓ 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.

2. Important Terms/Concepts used in Leverages

The following are a few terms/concepts which will be used throughout this chapter.
A. Types of Fixed Cost
Fixed Costs can be classified as follows:

Fixed Cost

Fixed Operating Cost Fixed Financial Cost

Eg: Interest on Debt;

Eg: Salary; Factory Rent etc.
Preference Divided

Note: If the question is silent, assume it as Fixed Operating Cost.

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 B. Marginal Costing Terminologies
✓ Variable Costs – Costs that vary with Sales
✓ Contribution = Sales (-) Variable Cost
Contribution
✓ Profit Volume Ratio (PVR) = × 100
Sales
✓ Break-Even Point (BEP) – A point of volume where the EBIT is equal to zero i.e total operating
cost is equal to total sales revenue.
Fixed Cost
BEP (in units) =
Contribution per unit
✓ Margin of Safety (MOS) – It refers to the sales level beyond the breakeven point
MOS = Actual Sales (-) Break Even Sales
C. Some Ratios used in Numerical Problems in this chapter
The following are some ratios used in the numerical problems in this chapter along with leverage
calculations. These are ideally a part of Ratio Analysis Chapter.
EFE
i. EPS =
No. of Equity shares
EFE
ii. ROE (Return on Equity) =
Equity shareholders fund
Where Equity shareholders fund = Equity shares capital (+) Reserves and surplus
MPS Market Price per share
iii. Price Earnings Ratio (PE Ratio) = =
EPS Earnings Per Share
EPS
iv. Earnings Price Ratio (Earning yield Ratio) =
MPS
Note: It is the Inverse of PE Ratio
Sales
v. Total asset turnover ratio =
Total assets
vi. Return on Capital Employed (ROCE) [Return on Investment (RoI)]
EBIT EBIT (1-T)
= (or)
Capital Employed Capital Employed
Where: Capital Employed = Equity + Retained Earnings + PSC + Debentures + LTL
vii. Coverage Ratios
EBIT
a) Interest Coverage Ratio =
Interest
EAT
b) Preference Dividend Coverage Ratio =
PD
EFE
c) Equity Dividend Coverage Ratio =
ED
EBIT
viii. Operating Profit Ratio = x 100
Sales

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 3. Types of Leverages

There are three commonly used measures of leverage in financial analysis.

Types of Leverages

Operating Leverage Financial Leverage Combined Leverage

It is the relationship
It is the relationship It is the relationship
between Sales and
between EBIT and EPS between Sales and EPS
EBIT

Indicates Business risk Indicates Financial Risk Indicates Total Risk

Chart Showing Degree of Operating Leverage, Financial Leverage and Combined leverage
Profitability Statement

Sales xxx

Less: Variable Cost (xxx) Degree of

Contribution xxx Operating
Leverage
Less: Fixed Cost (xxx)

Operating Profit/EBIT xxx

Less: Interest (xxx)

Degree of
Earnings Before Tax (EBT) xxx com bined
Leverage
Less: Tax (xxx)
Degree of
Earnings After Tax (EAT) xxx
Financial
Less: Pref. Dividend (xxx) Leverage

Net Earnings available to Equity Shareholders (EFE) xxx

No. Equity Shares (N) xxx

Earnings per Share (EPS) [EFE ÷ N] xxx

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 4. Operating Leverage

A. Meaning of Operating Leverage

✓ Operating Leverage (OL) measures the relationship between Sales and EBIT.
✓ It measures the 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:
o Amount of fixed cost,
o Variable contribution margin, and
o Volume of sales.
B. Operating Leverage Formulas
Operating Leverage can be calculated using the following formulas
✓ Formula - 1:
Percentage Change in EBIT
Degree of Operating Leverage (DOL) =
Percentage Change in Sales
✓ Formula - 2:
Contribution
Degree of Operating Leverage (DOL)=
EBIT
✓ Formula - 3:
1
Degree of Operating Leverage (DOL)=
Margin of Safety (%)
Note: "Degree of Operating Leverage (DOL)" and “Operating Leverage (OL)" are identical
words and can be used interchangeably.
C. Relationship between Break-Even Point, Fixed Cost and Operating Leverage
The relationship between Operating leverage, break-even point and fixed cost is as

under:

Operating Leverage Fixed cost Break-Even point

1. Firm with High OL 1. High fixed cost 1. Higher Break-even point

2. Firm with Low OL 2. Lower fixed cost 2. Lower Break-even point

D. Relationship between Margin of Safety (MOS) and Operating Leverage

✓ MOS refers to the sales level beyond the breakeven point
✓ Higher MOS indicates lower business risk indicating higher profit and vice versa.
✓ MOS is inversely related to OL.

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 If MOS Business Risk DOL (1/MOS)

Rises Falls Falls

Falls Rises Rises

E. Analysis & Interpretation of Operating Leverage

S. No. Situation Result

1 When No Fixed Cost No Operating Leverage (OL = 1)

2. When EBIT = 0 (Sales At BEP) OL is Undefined (OL = ∞)

3. When EBIT > 0 (Sales more than BEP) OL is Positive

4. When EBIT < 0 (Sales less than BEP) OL is Negative

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

5. Financial Leverage

A. Meaning of Financial Leverage

✓ Financial Leverage (FL) measures the relationship between EBIT and EPS.
✓ 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
✓ In short, FL is caused by Fixed Financial Cost (Interest & Preference Dividend).
✓ Financial leverage involves the use of funds obtained at a fixed cost in the hope of increasing
the return to common stockholders. This concept is also known as ‘Trading on Equity’
B. Financial Leverage Formulas
Financial Leverage can be calculated using the following formulas
✓ Formula - 1: General Formula
Percentage Change in EPS
Degree of Financial Leverage (DFL)=
Percentage Change in EBIT
✓ Formula - 2: When the co. has issued Preference Shares,
EBIT
Degree of Financial Leverage (DFL)=
PD
EBIT-Int-
(1-tax)
✓ Formula - 3: When the co. has not issued Preference Shares,
EBIT
Degree of Financial Leverage (DFL)=
EBT
Note: "Degree of Financial Leverage (DFL)" and “Financial Leverage (FL)" are identical words
and can be used interchangeably.
Doubt Busters:
1. Sometimes, ICAI uses Formula – 3 even when Preference Shares are issued. Therefore, when
Preference Shares are issued, students can either follow Formula - 2 or Formula – 3.

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2. Logically speaking, Formula – 2 is only correct when Preference Shares are issued.
C. Analysis & Interpretation of Financial Leverage
S. No. Situation Result

1 When there is No Fixed Financial Cost No Financial Leverage (FL = 1)

2. When EBIT level is equal to Fixed Financial Cost FL is Undefined (FL = ∞)

3. When EBIT level is more than Fixed Financial FL is Positive

Cost

4. When EBIT level is less than Fixed Financial Cost FL is Negative

D. 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 a 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”.

E. Financial Leverage as a ‘Double edged Sword’

✓ When the cost of ‘fixed cost fund’ is less than the return on investment, FL 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

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 ▪ When, ROI = Interest – Neutral – Neither advantage nor disadvantage
✓ This concept can be summarised as follows:

Financial Leverage

ROI > Kd = Positive / ROI > Kd = Negative /

Advantage Disadvantage

Example: Example:
ROI = 25% Kd = 15% ROI = 10% Kd = 15%

10% 5%
Surplus received to equity
shareholder i.e. EPS 

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

6. Combined Leverage

A. Meaning of Combined Leverage

✓ Combined Leverage (CL) measures the relationship between Sales and EPS.
✓ It indicates the effect the changes in sales will have on EPS.
✓ Combined leverage measures total risk. It depends on combination of operating and financial
risk.
✓ Therefore, CL is caused by both Fixed Operating & Fixed Financial Cost.
B. Combined Leverage Formulas
Combined Leverage can be calculated using the following formulas
✓ Formula - 1:
Degree of Combined Leverage (DCL) = DOL x DFL
✓ Formula - 2:
Percentage Change in EPS
Degree of Combined Leverage (DCL) =
Percentage Change in Sales
✓ Formula - 3: When the co. has issued Preference Shares,
Contribution
Degree of Combined Leverage (DCL) =
PD
EBIT-Int-
(1-tax)
✓ Formula - 4: When the co. has not issued Preference Shares,
Contribution
Degree of Combined Leverage (DCL) =
EBT

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 Note: "Degree of Combined Leverage (DCL)" and “Combined Leverage (CL)" are identical words
and can be used interchangeably.
Doubt Busters:
1. Sometimes, ICAI uses Formula – 4 even when Preference Shares are issued. Therefore, when
Preference Shares are issued, students can either follow Formula - 3 or Formula – 4.
2. Logically speaking, Formula – 3 is only correct when Preference Shares are issued.
C. Analysis & Interpretation 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.

Doubt Busters:
1. All the three leverages (OL, FL & CL) can be in positive or negative
2. Depreciation is treated as Fixed Operating Cost.
3. In case of reverse working problems when both OL & FL are given, alterative solutions are
possible depending on how students approach the question.

7. OL vs FL vs CL

DOL DFL DCL

Shows level of business risk. Shows level of financial risk. Shows level of total or

combined risk.

It is dependent upon fixed It is dependent upon interest It is dependent upon fixed

cost. and preference dividend cost, interest & preference

dividend.

Measures % change in EBIT Measures % change in EPS Measures % change in EPS

which results from a 1% which results from a 1% which results from a 1%

change in Sales. change in EBIT. change in Sales.

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For example, if DOL is 3 and For example, if DFL is 2 and For example, if DCL is 6 and

there is 8% increase in output there is 5% increase in EBIT there is a 8% increase in sales

then EBIT will increase by then EPS will increase by 10% then EPS will increase by 48%

24% & if there is a 8% and if there is a 5% decrease and if there is a 8% decrease

decrease in output then EBIT in EBIT then EPS will in sales then EPS will decrease

will decrease by 24%. decrease by 10%. by 48%.

There is a unique DOL for There is a unique DFL for There is a unique DCL for

each level of output. each level of EBIT. each level of sales.

It is undefined at Operating It is undefined at Financial It is undefined at Financial

B.E.P. B.E.P. B.E.P.

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