Leverage Analysis October 15,

2019

LEVERAGE ANALYSIS

Leverage:

There are primarily two types of leverages – Operating and Financial. The leverage
associated with investment (asset acquisition) activities is referred to as operating
leverage, while associated with financing activities is called financial leverage.
There are always some sources of funds on which fixed costs are incurred for
servicing them, the amount left for servicing other sources of finance vary greatly. i.e. ,
debenture is a source of fund on which interest is paid as a fixed cost. As a result the
return on equity shareholders changes greatly. Thus, return to shareholders is affected by
the amount of interest paid to debenture holders. In other words, return to shareholders
will vary with the size of debt in the capital structure of a firm. Hence when the volume of
sales change, leverage helps in determining its influence on the returns available to
shareholders. A high degree of leverage implies that there will be a large change in profits
due to a relatively small change in sales. Thus, higher is the leverage, the higher is the risk
and higher is the expected return.

Operating Leverage

The Operating Leverage may be defined as “the firm‟s ability to use fixed operating cost to
magnify the effects of changes in sales on its EBIT (Operating Profit).

Operating leverage occurs where a firm has fixed operating cost that must be met
regardless of volume of loss it may be defined as the firm‟s ability to use fixed operating
cost of majority the effects of changes in sales or its EBIT. The following definitions also
illustrate this point:

“Operating leverage exists when changes in revenues produces great change in EBIT.” –
John J. Hampton

“Operating leverage is the tendency of the operating profit to vary disproportionately with
sales. – Solomon Ezra

The degree of operating leverage depends on the amount of fixed burden capital in the
total value of capital structure. It can be determined with the help of break-even
techniques as follows:

Operating Leverage = Contribution OR Contribution OR Revenue – VC_____

Operating Profit EBIT Revenue – VC - FC

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Thus, operating profit results when fluctuations in sales revenue produce a wide fluctuation
in operating profit. High operating leverage involves a very risky situation because margin
of safety is very low. A low operating leverage, on the other hand, gives enough cushion to
the management providing a high margin of safety against the fluctuations of sales.

Operating Leverage may be favorable, if contribution exceeds fixed cost. In a reverse

situation, it will be unfavorable, when contribution is less than fixed cost.

Examples: The degree of leverage at any single sales volume can be calculated from a
ratio of contribution to EBIT. If the marginal contribution is Rs. 90,000 and EBIT is Rs.
45,000, the OL will be 90/45, or 2/1. Thus, any percentage increases in sales will results in
twice that percentage of EBIT. Thus, the degree of operating leverage [DOL] can be
determined follows:

DOL = Percentage changes in EBIT = CONTRIBUTION / EBIT

Percentage changes in Sales

Often corporate management in its enthusiasm to maximize the return on equity shares
follows a policy of high degree of leverage. It is dangerous. The limitations of the policy of
trading on equity must be always kept in mind. “Financial leverage is like a structure,
which requires a solid dependence on high financial leverage without paying adequate
attention to operating leverage results in a lop-sided capital structure.” So, this policy must
be adhered to only when the requirements of trading on equity are well satisfied. A mere
dependence on high leverage without adequate attention to operating leverage results in a
lop-sided capital structure high burden of fixed capital costs [rate of interest]; low profits
and ultimately early good for a healthy living for a healthy person. It is a double-edged
sword. It can be used by the management to magnify the share-holder‟s income under
favourable economic conditions only. Its use suggests the consideration of pertinent
variables before going for borrowings.

Effects of Financial Leverage on Shareholders

Company by using financial leverage tries to increase shareholder‟s profit. If there is a

favourable circumstance in the market then it increases shareholder‟s income. It is possible
only when company borrows securities lower than that of the shareholders rate of
dividend. But, if there is an unfavorable circumstance then it decreases profit.

Favorable Effect of Financial Leverage

Financial leverage is used as tool for increasing shareholder income without increasing
investment. If company can borrow the money at lower rate than what they are paying to
shareholders then it increases profit with the help of following example it can be easily
understand.

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Example:

Particulars Company A Company B

Assets 40, 00,000 40, 00,000
Liabilities: 10% Debentures --- 10, 00,000
Equity Capital each of Rs. 10 40, 00,000 30, 00,000
[4, 00,000 shares] [3, 00,000 shares]
Rate of Return on Assets before tax 20% 20%
Rate of tax 50% 50%

In above Example Company A is not using financial leverage, but company B is using financial leverage.
Both the companies have same rate of value of assets and same rate of return on assets, then also rate
of return on shares of company B is more. It shows advantage of financial leverage.

Solution:

Particulars Company A Company B

Profit before Interest and Taxes
@ 20% on total capital 8, 00,000 8, 00,000
Less: Interest on debenture of 10% --- 1, 00,000
Profit after Interest 8, 00,000 7, 00,000
Less: Taxes @ 50% 4, 00,000 3, 50,000

Profit after interest and tax 4, 00,000 3, 50,000

Net Profit
= Profit per share
No. of shares

For Company A = 4,00,000 = Re. 1

4, 00,000
For Company B = 3, 50,000 =Rs. 1.17
3, 00,000

Financial Leverage

“Leverage is the ratio of the net rate of return on shareholders‟ equity and the net rate of
return on total capitalization.” – Solomon Ezra

“Leverage may be defined as percentage return on equity to percentage return on

capitalization.” – James E. Walter

Thus, it results from the use of borrowed funds in financial structure with a rate of return,
and to degree can be determined in the following manner:

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DFL = Operating Profit or EBIT = EBIT = Percentage change in EPS [OR EBT]
EBT [= EBIT – Interest] EBT Percentage change in EBIT

So, now the effect of the policy of trading on equity can be measured with the help of
various leverage ratios available. The traditional approach of value comparison of debt and
equity in the total capitalization has been outmoded. In modern times the effect of
additional debt financing is measured in times of change in the earnings per share
available to equity shareholders. A successful financial leverage would always result in high
profit ability. As such, the financial leverage employed by a company is intended to earn
more on the fixed charges funds that their costs. The surplus will automatically increase
the return on the owner‟s equity, i.e., the rate of return on the equity share capital.

Combine leverage:

Operating leverage affects a firm‟s operating profit (EBIT), while financial leverage affects
profit after tax or the earning per share. The combined effect of two leverages can be quite
significant for the earnings available to the equity shareholders.

Operating and financial leverages together cause wide fluctuation in EPS for a given change
in sales. If a company employs a high level of operating and financial leverage, even a
small change in the level of sales will have dramatic effect on EPS. A company with cyclical
sales will have a fluctuating EPS; but the swings in EPS will be more pronounced if the
company also uses a high amount of operating and financial leverage.

The degrees of operating and financial leverage can be combined to see the effect of total
leverage on EPS associated with a given change in sales. The degree of combined leverage
(DCL) is given by the following equation:

Contribution X EBIT = CONTRIBUTION

DCL = EBIT EBT PROFIT BEFORE TAXES [EBT]

= % CHANGE IN EPS [OR EBT]

% CHANGE IN SALES

This combination can, however, prove risky for the company. If sales decline, the adverse
effect on EPS will be very severe. The right combination of operating and financial
leverages will differ among companies. It would generally be governed by the behavior of
sales. Public utilities such as electricity companies can afford to combine high operating
leverage with high financial leverage since they generally have stable or rising sales. A
company whose sales fluctuate widely and erratically should avoid use of high leverage
since it will be exposed to a very high degree of risk.

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Trading on Equity:

Introduction
While studying the problem of capital structure, it has been observed that companies do
not raise their entire capital by issuing equity share capital. They make use of funds from
external sources. A study of structure of Indian companies shows that almost all the
companies use funds raised from preference shares and debentures. Its proportion ranges
from 40 to 70 percent of the total capital. It has been found profitable, because if such
funds can be raised at a lower rate of interest, the profit increases by the amount of
difference. Thus, a higher dividend can be paid on equity shares. This situation is known as
„Trading on Equity or Financial Leverage”.

Meaning of Trading on Equity

One of the terms most frequently used in financial administration is trading on equity.
When a company uses fixed interest bearing capital (i.e. debentures and preference
shares) along with owned capital (i.e., ordinary shares) in raising finance, it is said to be
trading on equity. At this point it is necessary to clarify the meaning of „equity‟. Equity
represents owned capital of a company. Equity shareholders assume all the risks in
operating a business, including the possibility of losing their investments when the
company fails. The term „equity‟ has a wider meaning. It includes both equity share capital
and all free reserves of the company.

To be more precise, trading on equity represents an arrangement under which a company

uses funds carrying fixed interest of dividend in such a way as to increase the rate of
return on equity shares.

It is possible to raise the rate of dividend on equity capital only when the rate of interest
on fixed-interest-bearing-security is less than the rate of return earned in business. Two
other terms often used in this context are „trading on thick equity‟ and „trading on thin
equity‟. When borrowed capital is less than owned capital, is a case of trading on thick
equity. When borrowed capital is more than owned capital, it is called trading on thin
equity. Thus, the term trading on equity carries the same meaning as that of trading on
thin Equity.

Following illustration gives a clear idea of Trading on Equity:

Suppose a company needs capital of Rs. 1, 00,000 and expects to earn a profit of Rs,
10,000. If the entire capital is raised in the form of equity shares, it can give 10 per cent
dividend to equity shareholders. But if it resorts to trading on equity by raising Rs, 50,000
through the issue of debentures bearing 5 per cent interest, then it can give 15 per cent
dividend to its equity shareholders.

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Earning of the company Rs. 10,000

Less: interest (5% on debentures) Rs. 2,500
Earnings available for equity shares Rs. 7,500
Total capital Rs. 1, 00,000
Less: Debentures Rs. 50,000
Equity Capital Rs. 50,000

Profit of Rs. 7,500 will be distributed on equity capital of Rs. 50,000

So, Dividend = 7,500 x 100 = 15%

50,000
It follows that

(i) when capital is raised entirely in the form of equity shares, the rate of dividend is 10 per cent.
(ii) But through trading on equity, dividend rate can be increased to 15 per cent.

The conditions essential for success of trading on equity are as follows:

The rate of interest on borrowed capital must be lower than the rate of earnings on owned
capital. If it is the other way round, trading on equity will result into a loss to the equity
shareholders.

Supposing a company with a total capital of Rs. 1,00,000 can earn a profit of Rs. 5,000. If
it raises entire capital in the term of equity shares, the rate of dividend in 5 per cent. But if
it raises Rs. 50,000 through the issue of 8% debentures, then it will have to distribute Rs.
4,000 to debenture holders by way of interest and therefore a balance of Rs. 1,000 only
will be available to distribute among the equity shareholders. In other words, the dividend
rate is reduced to 2 per cent
1000 x 100
1 50,000

Computation of Trading on Equity

The rates of dividend on equity shares with trading on equity and without trading on equity
are to be calculated in the examples on this topic. The following points may be
remembered in this respect:

The rate of dividend on equity shares is calculated as follows:

Rate of Equity Dividend = Profit available to Equity Shareholders x 100
Equity Share Capital

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Remember that the profit available to equity shareholders means profit after interest and
taxes (i.e., PAT = Profit After Taxes).

Generally, the profit given in the example is profit before interest and taxes (i.e., EBIT =

Earning Before Interest and Taxes). The student must first ascertain as to which profit is
given. If it is EBIT, then debenture interest and taxes must be deducted there from as
under:
Rs.
Profit before interest and taxes [EBIT] …..
Less: Interest on debentures …..
Profit after interest …..
Less: Taxes …..
Profit after interest and taxes …..

If the company has also issued preference shares, then dividend on preference shares
must also be deducted for ascertaining profit available to equity shareholders.

Thus, from the profit

(i) Deduct debenture interest first
(ii) Then tax at 50% of the remaining amount must be deducted [if the rate of tax is given,
then it should be used]
(iii) Now preference dividend is deducted there from
(iv) Finally, the remaining amount is the profit available to equity shareholders and on that
basis the rate of equity dividend must be calculated as under:

Rate of dividend = Profit to Equity Shareholders x 100

Equity Share Capital

If the profit given in the example is profit after taxes [PAT], it means that interest on
debentures has also been deducted because tax is deducted only after deducting interest.
In such case, only preference dividend must be deducted from the profit and debenture
interest should not be deducted.
If it is stated in the example that the company transfers a particular amount to Reserves,
then such reserves should be deducted from the profit after interest and taxes. And the
rate of equity dividend must be calculated on the remaining amount.

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Calculations

1) Assume that a company requires an investment of Rs. 7, 50,00,000 to set up the

operations of the new plant. Five alternatives of capital structure are available as
follows:
(i) Case A: All Equity financing (Equity shares of Rs. 100 each)
(ii) Case B: Rs. 60,00,000 Equity share capital and Rs. 15,00,000 10%
Debentures
(iii) Case C: Rs. 45,00,000 Equity share capital and Rs. 30,00,000 10%
Debentures
(iv) Case D: Rs. 30, 00,000 Equity share capital, Rs. 30,00,000 10%
Debentures and Rs. 15,00,000 10% Preference share capital.
(v) Case E: Rs. 30,00,000 Equity share capital and Rs. 45,00,000 10% Preference
share capital

Assume that the Profit before interest and tax is Rs. 15, 00,000. The rate of tax is
50%. Which of these five alternatives would you suggest? Why?

2) A company is considering to buy a new plant which will require investment of Rs. 1,
00, 00,000. The plant is expected to earn a profit of Rs. 16,00,000 before interest
and taxes. In choosing a financial plan the company has an objective of maximizing
the EPS. It has three alternatives of issuing debentures of Rs. 15,00,000 of Rs.
40,00,000 of Rs. 70,00,000. The rates of interest in each of the alternatives would
be as follows:
Up to Rs. 15, 00,000: 9% p.a.
Between Rs. 15, 00,001 and Rs. 60, 00,000: 12% p.a.
Over Rs. 60, 00,000: 18% p.a.

The current price per equity shares is Rs. 25 and it is expected to drop to Rs. 20 if
the funds are borrowed in excess of Rs. 50, 00,000. Assume a tax rate of 50%. Give
your opinion on the basis of EPS in each of the above alternatives.

3) Calculate the DOL, DFL and DCL for the following three firms and interpret the
results:
Firms
A B C
Out put (units) 6,00,000 1,50,000 10,00,000
Fixed costs (Rs.) 6,00,000 17,50,000 1,50,000
Variable cost per unit (Rs.) 2.00 15.00 0.20
Interest on borrowed capital (Rs.) 8,00,000 8,00,000 Nil
Selling Price per unit (Rs.) 6.00 50.00 1.00

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4) The financial manager of ABC Ltd expects that its earnings before interest and taxes
in the current year would amount to Rs. 1, 00,000. The company has issued 10%
bonds aggregating Rs. 4, 00,000 and 7% preference shares amounting to Rs. 2,
00,000. The company has also issued 10,000 equity shares of Rs. 10 each.
Assuming the EBIT (a) Rs. 60,000 and (b) Rs. 1, 40,000, how would the EPS be
affected? What would be the degree of financial leverage? You may assume a tax
rate of 50%.

5) The capital structure of a company consists of Equity share capital of Rs. 10, 00,000
(share of Rs. 100 each) and 10% Debentures of Rs. 10, 00,000. Sales have
increased from 1,00,000 units to 1,20,000 units. The selling price is Rs. 10 per unit.
Variable cost is Rs. 6 per unit and fixed cost amounts to Rs. 2, 00,000. The income
tax rate is 50%.
(a) You are required to calculate the following:
(i) DOL, DFL and DCL at both the sales levels;
(ii) Percentage change in sales, EBIT, EBT and EPS

(b) Comment on the behavior of the leverages in relation to the change in sales
volume.

6) A firm has sales of Rs. 10, 00,000; variable cost of Rs. 7, 00,000, fixed cost of Rs. 2,
00,000 and debt of Rs. 5, 00,000 @ 10%. What are the DOL, DFL and DCL? If the
firm wants to double up its EBIT, how much of a rise in sales would be need on
percentage as well as amount basis?

7) A firm has sales of Rs. 75, 00,000, variable cost of Rs. 42, 00,000 and fixed cost of
Rs. 6, 00,000. It has a debt of Rs. 45, 00,000 at 9% and equity of Rs. 55, 00,000.
(a) What is the firm‟s ROI? [27%]
(b) Does it have favorable financial leverage?
(c) If the firm belongs to an industry whose asset turnover is 3, does it have high
or low asset leverage? [0.75]
(d) What are the operating, financial and combined leverages of the firm? [1.22;
1.18; 1.44]

(e) If the sales drop to Rs. 50,00,000, what will be the new EBIT? [Rs.
16,00,000]
(f) At what level the EBIT of the firm will be equal to zero? [Rs.22,92,000
(appx)]

8) Calculate operating and financial leverages under situations A, B and C and financial
plans I, II and III respectively from the following information relating to the
operation and capital structure of XYZ Ltd which produced and sold 800 units during
the last period. Also find the combination of operating and financial leverages which
give the highest and least value.
Selling price per unit: Rs. 30
Variable cost per unit: Rs. 20

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Fixed costs: Situation – A: Rs. 2,000; Situation – B: Rs. 4,000; Situation – C; Rs.
6,000
Capital structure Financial plan
I II III
Equity 10,000 15,000 5,000
Debt (12%) 10,000 5,000 15,000

9) From the following, prepare Income Statements of Company A, B and C. Briefly

comment on each company‟s performance:

A B C
Financial Leverage 3:1 4:1 2:1
Interest Rs. 200 Rs. 300 Rs. 1,000
Operating Leverage 4:1 5:1 3:1
Variable Cost as % to 66 2/3 % 75% 50%
sales 45% 45% 45%
Income tax rate

10) If the combined leverage and operating leverage of a company are 2.5 and 1.25
respectively, find the financial leverage and P/V Ratio given that the equity dividend
per share is Rs. 2, interest payable per year is Rs. 1,00,000, total fixed costs Rs.
50,000 and sales Rs. 10,00,000.

11) A new project under consideration requires a capital outlay of Rs. 300 lakh. The
required funds can be raised either fully by equity shares of Rs. 100 each or by
equity shares of the value of Rs. 200 lakh and by loan of Rs. 100 lakh at 15%
interest. Assuming tax rate of 50%, calculate the figure of profit, before interest and
tax that would keep the EPS equal under both the options. Also calculate that
amount of EPS.

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