Leverage

Leverage is that portion of the fixed costs which represents a risk to

the firm.

Types:-
•Operating leverage: a measure of operating risk, refers to the fixed operating
costs found in the firm’s income statement.
•Financial leverage: measure of financial risk, refers to financing a portion of
the firm’s assets, bearing fixed financing charges in hopes of increasing the return
to the common stockholders.
Combined leverage: Operating leverage affects a firm’s operating profit (EBIT),
while financial leverage affects profit after tax or the earnings per share.
The degrees of operating and financial leverages is combined to see the effect of
total leverage on EPS associated with a given change in sales.
 Meaning of Financial Leverage
• The use of the fixed-charges sources of funds, such as debt and
preference capital along with the owners’ equity in the capital
structure, is described as financial leverage or gearing or trading
on equity.
• The financial leverage employed by a company is intended to earn
more return on the fixed-charge funds than their costs. The surplus
(or deficit) will increase (or decrease) the return on the owners’
equity. The rate of return on the owners’ equity is levered above or
below the rate of return on total assets.
Financial Leverage= earnings before interest & tax
earnings before tax

Degree of F.L= percentage change in EPS

percentage change in EBIT
Example:-
Firm invest Rs10,00,000 with return of 15% ,and raises the entire amt through 1,00,000
equity shares of Rs 10 each. Find out financial leverage of the firm. Tax – 40%
and also find out if the profits are increased by 30%.

Particulars case 1 case 2 (30% )

EBIT (10 lakhs * 15%) 1,50,000 1,95,000
(-)Debenture - -

EBT 1,50,000 1,95,000

(- Tax (40%) 60,000 78,000

Earnings after tax 90,000 1,17,000

(/) no of equity shares 1,00,000 1,00,000
earnings per shares 0.9 1.17

FINANCIAL LEVERAGE 1 1
Degree of Financial leverage :
= percentage change in EPS
percentage change in EBIT

= (1.17 – 0.9) *100

0.9

(1,95,000 – 1,50,000) *100

1,50,000

= 30
30

= 1
 Operating Leverage
• Operating leverage affects Operating Leverage= contribution
a firm’s operating profit Earnings Before Interest & Tax
(EBIT).
• The degree of operating % Change in EBIT
leverage (DOL) is defined DOL 
% Change in Sales
as the percentage change
in the earnings before  EBIT/EBIT
DOL 
interest and taxes relative  Sales/Sales
to a given percentage
change in sales.
 Effect of Financial Plan on EPS and ROE:
Constant EBIT
• The firm is considering two Financial Plan
alternative financial plans:
– (i) either to raise the entire Debt-equity All-equity
funds by issuing 50,000 (Rs) (Rs)
ordinary shares at Rs 10 per
share, or 1. Earnings before interest and taxes, 120,000 120,000
EBIT
– (ii) to raise Rs 250,000 by
issuing 25,000 ordinary shares 2. Less: interest, INT 0 37,500
at Rs 10 per share and borrow
Rs 250,000 at 15 per cent rate 3. Profit before taxes, PBT = EBIT – INT 120,000 82,500
of interest.
• The tax rate is 50 per cent. 4. Less: Taxes, T (EBIT – INT) 60,000 41,250
5. Profit after taxes, PAT = (EBIT – INT) 60,000 41,250
(1 – T)
6. Total earnings of investors, PAT + INT 60,000 78,750

7. Number of ordinary shares, N 50,000 25,000

8. EPS = (EBIT – INT) (1 – T)/N 1.20 1.65

9. ROE = (EBIT – INT) (1 – T)/S 12.0% 16.5%

6
Effect of Leverage on ROE and EPS

Favourable ROI > i

Unfavourable ROI < i

Neutral ROI = i
 BREAK-EVEN ANALYSIS and IMPACT of LEVERAGE

The relationship between sales volume (revenue) and profitability

under different operating conditions provides information to managers
so they may plan for changes in the firm' s level of operations, financing
needs, and profitability.
Operating breakeven analysis deals only with the upper portion of
the income statement--the portion from sales to net operating income
(NOI), or earnings before interest and taxes (EBIT). This portion
generally is referred to as the operating section, because it contains
only the revenues and expenses associated with the normal production
operations of the firm.
 ANALYSIS and IMPACT of Operating Leverage
 

If fixed operating costs are presented in the firm’s cost structure, operating leverage
results.
High fixed costs arise from employing larger amounts of capital, thus permitting the
firm to operate with reduced labor and smaller variable costs.
A high degree of operating leverage means that a relatively small change in sales will
result in a relatively large change in operating income.
 
The degree of operating leverage (DOL) measures the effect of a change in sales
volume on earnings before interest and taxes (EBIT). It is defined as the percentage
change in EBIT associated with a given percentage change in sales:
EBIT  
Q(P - V) EBIT  + F
DOL = EBIT = =
SALES Q(P - V) - F EBIT
SALES
 Sales - Variable cost GrossProfi t
DOLS = =
Sales - Variable cost - Fixed cost EBIT

The degree of operating leverage can also be stated in terms of sales

revenue, DOLS:
• The higher the degree of operating leverage, the more profits will
fluctuate, in both an upward and a downward direction, in
response to changes in sales volume.
• The closer a firm is to its operating breakeven point, the greater is
its degree of operating leverage.
• It generally can be concluded the higher the DOL for a particular
firm, the closer the firm is to its operating breakeven point, and the
more sensitive its operating income is to a change in sales volume.
• Firms with higher DOLs generally are considered to have riskier
operations than firms with lower DOLs.
 Measures of Financial Leverage
• Debt ratio
• Debt–equity ratio
• Interest coverage

The first two measures of financial leverage can be expressed

either in terms of book values or market values. These two
measures are also known as measures of capital gearing.
The third measure of financial leverage, commonly known as
coverage ratio. The reciprocal of interest coverage is a
measure of the firm’s income gearing.
Measurement of Financial leverage :

 The ratio of debt to total capital

L= Debt or Debt
Debt + Equity Total capital
 The ratio of debt to equity
L = Debt
Equity
 The ratio of net operating income to interest charges
L = EBIT
Interest
Effect on share holders returns is calculated on 2 factors :
 Earnings per share = Profit after tax
no of outstanding shares

 Return on equity = Profit after tax

net worth on equity capital
 COMBINED LEVERAGE
It is a combination of operating leverage & financial leverage . It may be defined as
a use of assets having fixed cost as well as securities having fixed charges to
magnify the operating profits as well as the earnings per share with the relevance.

It is denoted by :

C.L = operating leverage * financial leverage

OR contribution
EBT

Degree of combined leverage

= percentage change in EPS

percentage change in sales
 CAPITAL STRUCTURE
“Capital structure of a company refers to its CAPITALIZATION .It includes
all long term sources .i.e. loans, reserves , shares & bonds “

Capitalization refers to the determination of amount of capital to be raised &

the relative proposition of the various types of securities to be issued & the
administration of the capital.

capitalization includes only long term sources of funds while the term capital
includes both long term & short term sources of funds.
There are 2 set of factors which influence capital structure , namely :
 Internal factor
 External factor

Internal factor :
1. Financial leverage
2. Risk
3. Growth & stability
4. Retaining control
5. Cost of capital
6. Cash flow
7. Flexible
8. Purpose of finance
9. Assets structure
External factor :
1. Size of business
2. Nature of industry
3. Investors
4. Cost of flotation/ issue
5. Legal requirements
6. Periods of finance
7. Level of interest rate
8. Level of business activity
9. Availability of funds
10. Taxation policy
11. Level of stock prices

Features of appropriate capital structure:

12. Profitability
13. Solvency
14. Flexibility
15. Capacity
16. control