a = Pe vere, it Verage ob » b UE tO a relativel: ‘ge in sales and vice versa. However, a higher leverage obvious — tively coal MABE TP ene riskier if the sales of the firm take a sudden di eat es Hher ae ine or isthe risk and higher is dhe retum to equity shareholders, en" Me Hesree of Types of Leverages crerage is af three types ¢ (o) Operating Leverage, | qi) Financial Leverage, and | (i Combined Leverage. ‘5 operating Leverage : Operating leverage may be defined asthe tendency ofthe operating pric Ghovonomionately with the volume of sales. It occurs whem a firm has faed costs that ent be yesn OM fess of volume of sales. In other words, with fixed costs, the percentage change in operating nities greater than the percentage change in sales. This tendency is called operating leverage. The (et of operating leverage depends upon the proportion of fixed costs as compared to variable costs, ire proportion of fixed costs is higher than the variable costs, it will have a higher degree of operating ee retOn the other hand, if the proportion of fixed costs is lower than the variable costs, it wll have id~-------~ LR St SE aaah i erage, the operating or, a lower operating leverage. In case of higher degree of Tae ere iain: erating pr increase at a higher rate as compared to the rate of increase in sal sa, Computation : The operatin® leverage can be calculated as : ___ Contribution ~ Operating Profit Contribution = Sales — Variable Cost Operating Profit Sales — Variable Cost — Fixed Cost Operating profit here means “Eamings before interest and tax”’ (BIT). Operating leverage may be favourable or unfavourable. It will be fayourable when contribiaica) sales less variable cost) exceeds the fixed cost and it will be unfavourable when contribution iso than the fixed cost. iperating Leverage Degree perating Leverage : € degree of operating leverage may be defined as the percentage change in operating pu! Sulting from a percentage change in sales, Deitee of Operating Leverage = Refeentaue Change in Operating Profits Percentage Change in Sales ated ai re ST aLEVERAGES ce of financial risk. Both these leverazes, a rages an - ed costs (both operating and finangialy mae med wih ; ; . ath the leverag ' jet the effect of change in Sales level on the caning belmeter cent are combined, the Therefore, combined leverage depicts the telationship between revenu; contribution or sales Less variable cost) and the eaming before tae tegen om Se Tales ( Th other y aring belore tax on account of change in contribution. It may be cale eee me fol Combined, 2 ——Lontribution 7 Eaming before tax (EBT) OR Combined Leverage = Operating Leverage x Financial Leverage Degree of Combined Leverage may be calculated as follo’ - Pereentage Change in EPS Percentage Change in Sales iow Degree of Combined Leverage ‘cnificance of Combined Leverage : . = z ') Understanding Changes in EPS : Combined leverage explains the combined ees ne ave and financial leverage of a firm on its earnings per share (EPS). Thus, it explFinancial leverage of 2 indicates that every |e change Im hit) will result “Suit in 2% chang change in EBT, ror example. in the above case if EBIT increases by 50%, impact on EBT will be as follows EBIT (after $0% increase) 80,000 a 7 120,000, Less : Interest on Debt EBT 10.000, ~so000 EBT has increased from 40,000 to £80,000 ie. 100% increase. Thus financial leverage of 2 ‘es that 50% inerease in EBIT has resulted in 100% increase in EBT. a Degree of peel Leverage : It, may“be defined as percentage change in earning per share (EPS) that results from a given percentage change in earnings before interest and tax (EBIT). It is calculated as follows _— __ Percentage Change in EPS ¢ of Financial Leverage ~ percentage Change in EI De Significance of Financial Leverage : (1) Understanding Changes in Earning before Tax (EBT) ee. ery) aga result of changes + Financial leverage helps 1 n Eaming before interest "+ CRIT will resultti) FINANCIAL LEVERAGE : Financial leverage arises on account of existence of fixed interest or fixed pref urities in the total capital structure of the firm. In other words, financial ley Praising of capital from those sources on which fixed return has to be paid, su. f along with owner's equity in the capital structure. The fixed return op on debt or preference capital do not vary with the earnings before interest ang iless of the amount of EBIT. After paying fixed charges ou dinary shareholders. ge may be defined as the tendency of the residual net ine th EBIT. In other words, the financial leverage indicates the chaig: result of change in EBIT. The ratio is expressed as tolly ing before interest & tax (EBIT) Earning before tax (EBT) ) akinancisl-teVerag EBT - EBIT — Fixed Interest Charges! Favourable and unfavourable fimancial leverage = Financial leverage may be dep upon whether the eamings made by the use of fixed cost securities ch the firm has to pay on them. For example, if'a company borrows ©1004! Ii" rn of 12%, the leverage will be considered favourable. LUinfavourable wn ,¢ firm does not earn as much as the cost of debt. Favourable une ut ‘trading on equity’.