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Financial and Operating Leverage

The document discusses capital structure, emphasizing the relationship between debt and equity in financing decisions. It explains the concepts of financial and operating leverage, their impact on shareholder returns, and the calculations for earnings per share (EPS) and return on equity (ROE). Additionally, it outlines the degrees of leverage and their combined effects on a firm's financial performance.

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11 views18 pages

Financial and Operating Leverage

The document discusses capital structure, emphasizing the relationship between debt and equity in financing decisions. It explains the concepts of financial and operating leverage, their impact on shareholder returns, and the calculations for earnings per share (EPS) and return on equity (ROE). Additionally, it outlines the degrees of leverage and their combined effects on a firm's financial performance.

Uploaded by

Unknown01
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Financial and Operating Leverage

Capital Structure
 The term capital structure is used to represent
the proportionate relationship between debt
and equity.
Questions while making the Financing
Decisions
 How should the investment project be
financed?
 Does the way in which the investment
projects are financed matter?
 How does financing affect the shareholders’
risk, return and value?
 Does there exist an optimum financing mix in
terms of the maximum value to the firm’s
shareholders?
 Can the optimum financing mix be determined
in practice for a company?
 What factors in practice should a company
consider in designing its financing policy?
Meaning of Leverage
 Leverage refers to the use of an asset or
source of funds which involves fixed costs or
fixed returns.
 As a result, the earnings available to the
shareholders / owners are affected as also
their risk.
 There are three types of leverages :
 Operating
 Financial and
 Combined
Meaning of Financial Leverage
 Financial leverage is related to the financing
activities of a firm. It results from the presence
of fixed financial charges (such as interest on
debt and dividend on preference shares).
 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.
 It is defined as the ability of a firm to use fixed
financial charges to magnify the effect of
changes in EBIT on the earnings per share (EPS).
Measures of Financial Leverage
 Debt Ratio
 The ratio of debt to total capital, i.e.,

 Debt – Equity Ratio

 Interest Coverage
Financial Leverage and
Shareholder’s Return
 The primary motive of a company in using
financial leverage is to magnify the
shareholders’ return under favourable
economic conditions. The role of financial
leverage in magnifying the return of the
shareholders’ is based on the assumptions
that the fixed-charges funds (such as the
loan from financial institutions and banks
or debentures) can be obtained at a cost
lower than the firm’s rate of return on net
assets (RONA or ROI).
EPS and ROE Calculation

Profit after tax


Earningsper share =
Numberof shares
PAT ( EBIT  INT)(1  T )
EPS = 
N N
Profit after tax
Return on equity =
Value of equity
(EBIT  INT)(1  T )
ROE =
S

 For calculating ROE either the book value or


the market value equity may be used.
Effect of Leverage on ROE and EPS

Favourable ROI > i

Unfavourable ROI < i

Neutral ROI = i
Alternative Definition of Financial
Leverage
 The procedure outlined above is merely indicative
of the presence or absence of financial leverage.
Financial leverage can be more precisely expressed
in terms of the degree of financial leverage (DFL).
Percentage change in EPS
DFL 
Percentage change in EBIT
EBIT
DFL 
EBT
Operating Leverage
 Leverage associated with asset
acquisition or investment activities is
referred to as the operating leverage.
 The degree of operating leverage (DOL) is
defined as the percentage change in the
earnings before interest and taxes relative to
a given percentage change in sales.
 The operating leverage is favourable when
increase in sales volume has a positive magnifying
effect on EBIT. It is unfavourable when a decrease
in sales volume has a negative magnifying effect
on EBIT. Therefore, high DOL is good when sales
revenues are rising and bad when they are falling.
 The DOL is a measure of the business/operating
risk of the firm. Operating risk is the risk of the
firm not being able to cover its fixed operating
costs. The larger is the magnitude of such costs,
the larger is the volume of sales required to
recover them. Thus, the DOL depends on fixed
operating costs.
Alternative Definition of Operating
Leverage
 When proportionate change in EBIT as a result
of a given change in sales is more than the
proportionate change in sales, operating
leverage exists. The greater the DOL, the
higher is the
DOL 
operatingchange
Percentage leverage. Symbolically,
in EBIT
Percentage change in sales
Contributi on
Alternatively, DOL 
EBIT
Combining Financial and Operating
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.
Combining Financial and Operating
Leverage
 The degree of combined leverage (DCL) is
given by the following equation:
% Change in EBIT % Change in EPS % Change in EPS
  
% Change in Sales % Change in EBIT % Change in Sales
 another way of expressing the degree of
combined leverage is as follows:

Contribution
DCL 
EBT
 DOL = % change in EBIT / % change in sales
 DOL = Contribution / EBIT

 DFL = % change in EPS / % change in EBIT


 DFL = EBIT / EBT

 DCL = % change in EPS / % change in Sales


 DCL = Contribution / EBT
 DCL = DOL x DFL
 BEP = Fixed cost divided by Contribution
Ratio
 Contribution Ratio = Contribution divided by
Sales
 Profit Margin = Profit divided by Sales
Thank You

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