 Leverage Analysis

Leverage refers to the use of fixed cost assets or funds to increase the return to its
shareholders. It is considered as an investment strategy that involves borrowing of funds to
finance the purchase of company assets. In simpler terms, Leverage is the use of borrowed
capital in order to increase the return from a project. This concept of leverages is used both by
the firms as well as investors. Investors use leverage to multiply their buying power in the
market while the firms use leverage to finance their assets.

 Types of Leverage

There are three types of leverages:

1. Operating Leverage
The leverage associated with investment activities is called as operating leverage. It is defined as
the company’s ability to use fixed operating costs to highlight the effects of changes in sales on
its earnings before interest and taxes. It is used to measure the impact of changes in sales which
lead for change in the profits of the company. Operating leverage is high when the firm requires
high amount of fixed cost and lower variable cost for the production purposes.

The degree of operating leverage is defined as percentage change in the profits resulting from a
percentage change in the sales.

Degree of Operating Leverage = % Change in EBIT/ % Change in Sales

2. Financial Leverage
Financial leverage is defined as the ability of a firm to use fixed financial charges to
highlight the effects of changes in EBIT on the earnings per share. It involves the use of funds
obtained at a fixed cost to increase the return to the shareholders. Financial leverage is of two
types favourable or unfavourable depending upon the use of fixed cost funds. It increases with
the increasing level of debt.
Degree of financial leverage is defined as the percentage change in taxable profit as a
result of percentage change in earnings before interest and tax (EBIT).

Degree of Financial Leverage = % Change in PBT/ % Change in EBIT

3. Combined Leverage
The measure of the risk faced by a company is referred as combined leverage of a firm. It is
defined as the total magnification of returns. When the company uses both financial and
operating leverage to magnification of any change in sales into a larger relative change in
earning per share. It is also known as composite leverage or total leverage.
Degree of Combined Leverage is the percentage change in a firm’s earning per share (EPS)
results from one percent change in sales

Combined Leverage = % Change in PBT/ % Change in Sales

ANALYSIS

The following data is extracted from the financial statement of the firm and is used to
calculate DOL, DFL and DTL for the financial year 2017. 2018, 2019.

The DOL for year 2016-2017 is quite high which decreases sharply in the next year and tends to
negative for 2018-2019. High DOL in 2016-2017 implies that the firm was having a huge
increase in EBIT but a small increase in the sales in during that period, causing a high business
risk for the firm. While on the other hand, DFL is more or less same for all the three years with a
very small but constant increase in all the three years hence this implicates that the amount of
debt was increasing slowly but steadily creating a little of financial risk for the firm. Since DTL
is an amalgamation of both DOL and DFL it too keeps on fluctuating for the given time period.
 Components/Year 2016-2017 2017-2018 2018-2019 2015-2016
         
Net Sales 30983.66 33100.94 33972.23 30715.33
Change in Net Sales 0.008736029 0.068335374 0.026322213  
Percentage Change in Net Sales 0.873602856 6.833537419 2.632221321  
         
EBIT 4912.68 5322.9 5141.48 4401.61
Change in EBIT 0.116109787 0.083502284 -0.034082925  
Percentage Change in EBIT 11.61097871 8.350228389 -3.408292472  
         
PBT 4885.4 5292.1 5104.3 4387
Change in PBT 0.113608388 0.083248045 -0.035486858  
Percentage Change in PBT 11.36083884 8.32480452 -3.548685777  
         
Degree of Operating Leverage=
%Change in EBIT/%Change in 13.29091204 1.221948147 -1.294835068  
Sales
Degree of Financial Leverage=
%Change in PBT/%Change in 0.978456608 0.996955309 1.041191683  
EBIT
Combined Leverage= %Change in
13.00458071 1.218227692 -1.348171504  
PBT/%Change in Sales
 Leverage

2018-2019

2017-2018

2016-2017

-4 -2 0 2 4 6 8 10 12 14 16

DOL DFL DTL