Leverage Analysis

DR H S BAGGA
 Introduction of Leverage
• ‘Leverage’ is the action of a lever or the mechanical advantage gained by it;
it also means `effectiveness' or `power'. The common interpretation of
leverage is derived from the use or manipulation of a tool or device termed
as lever, which provides a substantive clue to the meaning and nature, of
financial leverage.
• Leverage is the use of debt (borrowed capital) in order to undertake an
investment or project. The result is to multiply the potential returns from
a project. At the same time, leverage will also multiply the potential
downside risk in case the investment does not pan out. When one refers to
a company, property, or investment as "highly leveraged," it means that
item has more debt than equity.
 Uses of Leverage

The concept of leverage is used by both investors and companies. Investors

use leverage to significantly increase the returns that can be provided on
an investment. They lever their investments by using various instruments,
including options, futures, and margin accounts.
Companies can use leverage to finance their assets. In other words, instead of
issuing stock to raise capital, companies can use debt financing to invest in
business operations in an attempt to increase shareholder value.
 Definition of Leverage

• Leverage is common term in financial management which entails the ability

to amplify results at a comparatively low cost. In business, company's
managers make decisions about leverage that affect profitability.
According to James Horne, leverage is, "the employment of an asset or fund
for which the firm pays a fixed cost or fixed return". When they evaluate
whether they can increase production profitably, they address operating
leverage. If they are expecting taking on additional debt, they have
entered the field of financial leverage. Operating leverage and financial
leverage both heighten the changes that occur to earnings due to fixed
costs in a company's capital structures.
 Definition of Leverage

• Fundamentally, leverage refers to debt or to the borrowing of funds to

finance the purchase of a company's assets. Business proprietors can use
either debt or equity to finance or buy the company's assets. Use of debt, or
leverage, increases the company's risk of bankruptcy. It also rise the
company's returns, specifically its return on equity. It is a fact because, if
debt financing is used rather than equity financing, then the owner's
equity is not diluted by issuing more shares of stock. Investors in a business
like for the business to use debt financing but only up to a point. Investors
get nervous about too much debt financing as it drives up the company's
default risk.
 Types of Leverage
LEVERAGE
A. OPERATING LEVERAGE
B. FINANCIAL LEVERAGE
C. COMBIND LEVERAGE
 A. OPERATING LEVERAGE
• The leverage related with investment activities is known 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 comprises of two important costs viz., fixed cost and
variable cost. Operating leverage augments changes in earnings before
interest and taxes (EBIT) as a response to changes in sales when a company's
operational costs are comparatively fixed.
• Operational leverage is the use of fixed operating costs by the firm.
Operating leverage reproduces the impact on operating income of a change
in the level of productivity.
 A. OPERATING LEVERAGE
• Operating leverage measures the extent to which a firm or specific project
needs some cumulative of both fixed and variable costs. Fixed costs are
amount not changed by an increase or decrease in the
• total number of goods or services a company produces. Variable costs can
be defined as the costs that differ in direct relationship to a company's
production.
• Variable costs rise when production upturns and fall when production drops.
Businesses with higher ratios of fixed costs to variable costs are
considered as using more operating leverage, while businesses with
lower ratios of fixed costs to variable costs use less operating leverage.
 A. OPERATING LEVERAGE

• Operating leverage can be calculated with the help of the following formula:

Operating Leverage = Contribution

EBIT
OL = C/EBIT
Where,
• OL = Operating Leverage
• C= Contribution
• EBIT- Earnings Before Interest and Tax
 A. OPERATING LEVERAGE

• Utilizing a higher degree of operating leverage rises the risk of cash flow problems that
results from errors in forecasts of future sales. One possible effect caused by the
presence of operating leverage is that a change in the amount of sales results in a
"more than proportional" change in operating profit (or loss).
• The degree of operating leverage (DOL)
•DOL = Percentage change in EBIT > 1
Percentage change in Sales
• The degree of operating leverage is directly proportionate to a firm's level of business
risk
 Uses of Operating Leverage

• Operating leverage is one of the procedures to measure the impact of

changes in sales which lead for change in the profits of the company. If there
is any change in the sales, it will lead to corresponding changes in profit.
• Operating leverage assists to identify the position of fixed cost and variable
cost.
• 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 defines the overall position of the fixed operating cost.
 Impact of Operating Leverage

• A high operating leverage entails that company has increased production

without investing in additional fixed costs. As production rises, managers
are in effect spreading fixed costs across a greater number of units, so the
additional units have a lower ratio of fixed costs to total costs. When
demand for company product increases, then experts can easily ramp up
production by increasing variable costs; Company's fixed assets allow to
magnify production. Managers can increase production as long as their
higher variable costs do not cause total costs to exceed their sales revenues.
 Financial leverage

• Financial leverage characterizes the relationship between the company's earnings

before interest and taxes (EBIT) or operating profit and the earning available to
equity shareholders. Financial leverage increases as how earnings per share (EPS)
change as a result of changes in EBIT where the fixed cost is that of financing,
specifically interest costs.
• Financial Leverage is the use of fixed financing costs by the firm. Financial leverage is
attained by choice. It is used as a means of increasing the return to common
shareholders (Pearson South Africa, 2007). Financial leverage mirrors the impact on
returns of a change in the extent to which the firm's assets are financed with
borrowed money.
 Financial leverage
• Financial leverage can be calculated with the help of the following formula:
FL = OP(EBIT)
PBT
Where,
• FL = Financial leverage
• OP = Operating profit (EBIT)
• PBT = Profit before tax
 Financial leverage

• The degree of financial leverage (DFL) measures a percentage change of

earnings per share for each unit's change in EBIT that result from a
company's changes in its capital structure. Earnings
• per share become more volatile when the degree of financial leverage is
higher. The degree of financial leverage (DFL) is calculated as follows:
DFL = Percentage change in EPS >1
Percentage change in EBIT
 Financial leverage

• This measure of degree of financial leverage DFL is affected by the initial

earnings EBIT. This measure of financial leverage is not suitable to compare
companies whose initial profits and earnings that are most certainly different,
and it is also inadequate for comparisons over time for the same company.
• Financial leverage expands earnings per share and returns because interest is a
fixed cost. When a company's revenues and profits are on the rise, this leverage
works very favorably for the company and for investors. Nevertheless, when
profits are pressured or falling, the exponential effects of leverage can become
challenging.
 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 pinpoints the correct profitable financial decision regarding capital structure of the
company.
• Financial leverage is vital devices which is used to measure the fixed cost proportion with the total capital
of the company.
• If the firm obtains fixed cost funds at a higher cost, then the earnings from those assets, the earning per
share and return on equity capital will decrease.
• There is a difference between operation and financial leverages:
 Combined leverage

• When the company utilizes both financial and operating leverage to

amplification of any change in sales into a larger relative changes in earning
per share. Combined leverage is also known as composite leverage or total
leverage. Combined leverage shows the relationship between the revenue in
the account of sales and the taxable income.
 Combined leverage
• Combined leverage can be calculated with the help of the following
formulas:
CL = OL x FL OR C x EBIT
EBIT PBT
• Where,
• CL = Combined Leverage
• OL = Operating Leverage
• FL = Financial Leverage
• EBIT = Earnings before Interest and Tax
• PBT = Profit Before Tax
 Degree of Combined Leverage

• The percentage change in a firm's earning per share (EPS) results from one
percent change in sales. This is also equal to the firm's degree of operating
leverage (DOL) times its degree of financial leverage (DFL) at a particular
level of sales.
 Conclusion

• To summarize, Operating leverage is the degree to which a firm's fixed

production costs contribute to its total operating costs at different levels of
sales. In a firm that has operating leverage, a given change in sales results in
major change in the net operating revenue. Financial leverage calculates the
sensitivity of the firm's net income to changes in its net operating income
(NOI). On the contrary to operating leverage, which is determined by the
firm's choice of technology (fixed and variable costs), financial leverage is
dogged by the firm's financing selections (the mix of debt and equity).
 Importance of Leverage
• 1. Helpful in managerial decisions-The managers of business use this
technique frequently in managerial decision making. The concept of
leverage is most helpful in deciding upon financial structure. The proportion
of various sources of finance is fixed in such a way that overall cost of capital
is the lowest.
• 2. Helpful in investment decision-Leverages are used advantageously by the
financial management of a business concern in taking investment decisions.
Whether a firm should go for expansion plan? Which project should be
selected? The answer to all such questions can be easily given by the
analysis of leverages.
 Importance of Leverage
• 3. Increase in EBIT-Because of the existence of fixed cost EBIT increase more
than proportionate change in sales. If there is no fixed cost, operating
leverage will be 1, which shows absence of operating leverage. Thus with the
help of the study of operating leverage one can easily understand the
relationship of sales, contribution, fixed cost and earning before interest and
tax.
• 4. Helpful in magnifying the income of equity shareholders-The study of
financial and combined leverages helps financial managers how to increase
the earnings of equity
 Limitations of leverages

• As stated earlier, leverage is a double edged sword which is profitable on

one side, and harmful on other side, the application of leverage must be
made after a careful study of all the other factors. It suffers from following
drawbacks also-
• 1. Ignorance of implicit cost-In the calculation of various leverages only
explicit costs are considered but implicit costs are ignored which is not
logical.
 Limitations of leverages
• 2. Cost of loan capital varying-Analysis of leverage assumes the explicit cost
to be constant which is not a true fact. The lending or borrowing rates of
interest fluctuates according to the counteracting forces of demand and
supply of money in capital market.
• 3. Difficult in calculation-Many a time, a financial manager, faces difficulty in
the calculation of leverages when several limiting factors operate at a time
and make the computation of leverages more and more complexed.
 Indifference Point
• The EBIT level at which the EPS is the same for two alternative financial
plans is referred to as the indifference point. In other words, it is the level of
EBIT beyond which the benefits of financial leverage begin to operate with
respect to earnings per share (EPS).
• If the expected level of EBIT is more than the indifference level, the use of
fixed-charged source of funds (i.e. debt) would be advantageous from the
EPS point of view. In this case, financial leverage would be favorable and
would lead to an increase in the EPS available to the shareholders.
• If, however, the expected level of the EBIT is less than the indifference level,
the advantage of EPS would be available from the use of equity capital.
 Formula for Indifference Point
• When only equity shares and debentures are issued-

x (1-t) = (x-I) (1-t)

N₁ N2
Here x = EBIT at point of indifference
N₁ = Number of equity shares when only equity share are issued.
N2 = Number of equity shares when debentures and equity shares are issued.
I = Interest on debentures
t= tax rate / 100
 Formula for Indifference Point
• (ii) When only equity shares and preference shares are issued-
x (1-t) = x (1-t)-P
N₁ N3
Here x = EBIT at point of indifference
N₁ = Number of equity shares when only equity share are issued.
N3 = Number of equity shares when preference shares and equity shares are
issued.
P=Preference dividend.
t= tax rate / 100
 Formula for Indifference Point
• (iii) When equity shares, preference shares and debentures are issued-
x (1-t) = (x-I) (1-t)-P
N₁ N4
Here x = EBIT at point of indifference
N₁ = Number of equity shares when only equity share are issued.
N4 = Number of equity shares when debentures, preference shares and
equity shares are issued.
I = Interest on debentures
P=Preference dividend.
t= tax rate / 100
 Thanks

Dr H S Bagga