Unit 3 : Leverages

A business can increase its funds by increasing owner’s funds or creditors or both.
Owner’s claims/funds increase when the firm raises funds by issue of Equity Shares or by retaining the
profits/reserves. Creditor’s claims increase by borrowings/debt.
The mix of these sources is called Capital Structure or Financial Structure. Capital Structure decisions are very
important for the management of a firm.
Leverage implies the ability of a firm to use Fixed Cost Assets/ Funds in order to magnify the return to its
Equity Shareholders.
Fixed costs have to be paid irrespective of Production, Sales. These fixed costs affects the profits available to
the shareholders .A small increase or decrease in sales can increase or decrease the profits of the firm to a
greater extent.
Importance of Leverages:
i] Leverages indicate ability of firm to use Fixed Costs to magnify the returns to its shareholders
ii]Leverages helps in examining a relative change in profits due to change in the sales
iii]Leverages help in determining increase/decrease in profit due to change in Fixed Costs
iv]Leverages help in bifurcating fixed costs into Operating and financial ,and thus examine its impact on the
profits of the firm independently
v] Leverages help in determining the EPS[Earning Per Share] of the company

I] Types of Leverages
There are 3 types of leverages namely Operating Leverage, Financial Leverage and Combined Leverage
a] Operating Leverage
-Total Cost of a firm consists of 2 types of costs namely Variable Costs and Fixed Costs.
-Variable Costs vary in direct proportion to the output and sales. Fixed Costs are those costs which are not
affected by change in output and sales i.e they remain fixed/constant
-When a firm uses such an asset for which it has to pay fixed costs, then that is Operating Leverage
-Operating Leverage exists only if there are Fixed Operating Costs [Eg.Rent of Premises ,Factory Rent etc]
-If Fixed Operating Costs >Variable Operating Costs ,Then operating Leverage will be higher and vice versa.
-Thus, Operating Leverage is the use of Fixed Costs to magnify a change in profits relative to a given change in
sales
-Operating Leverage = Contribution Sales-Variable Costs
OR ---------------
------------------------ EBIT
EBIT [i.e Operating Profit]

-If Contribution > Fixed Costs , there is a favourable operating leverage.

-If Contribution < Fixed Costs , there is a unfavourable operating leverage.
Example:
A ltd. Sells 200 units p.a The Selling Price per unit is Rs.30 and Variable costs per unit is Rs.7
The fixed Operating costs is Rs.500 p.a
Calculate Operating Leverage
Sales [200 units * 30 p.unit] 6000
Less: Variable Costs [200 units * 7 p.unit] (1400)
--------
Contribution 4600
Less: Fixed Costs 500
-------
Operating Profit[EBIT] 4100
Operating Leverage = Contribution
--------------
EBIT
=4600
----- = 1.12
4100
b] Financial Leverage
-It indicates effect on earnings due to rise of fixed cost funds
-Financial Leverage arises when a firm raises finance thru securities which involve fixed charges [eg. Interest
on Debentures/Loans]
-Interest on debt is fixed.
-Effect of fixed cost securities on Earnings per share [EPS] is due to the use of fixed rate bearing securities.
-Financial leverage may be favorable or unfavorable.It is favorable when the firm’s earnings by use of fixed
interest bearing securities is more than their fixed cost . It is called Trading on Equity.
-It is unfavourable when the firm’s earnings are less than the cost of debt.
-Financial Leverage= EBIT
------
EBT
If there is preference dividend: EBIT
-----------------------------------
EBIT – (Pref Dividend/1-tax)
-Example :
S ltd. Has foll.Capital Structure:
Equity Capt 50,000
8% Debentures 40,000
Present EBIT is Rs.25,000 ;Tax rate is 50% .Calculate Financial Leverage
Operating Profit[EBIT] 25,000
-Int on debentures (3200)
---------
EBT 21,800
Financial Leverage =EBIT
------
EBT
Financial Leverage = 25,000
------ = 1.146
21,800

c] Combined Leverage/ Composite Leverage

Operating Leverage and Financial Leverage are combined to assess the impact of all types of Fixed Costs. It is
thus the relationship between contribution and taxable income.

Combined Leverage = Operating Leverage * Financial Leverage

OR
Combined Leverage= Contribution
---------------
EBT
Example:
Y Ltd. Has sales of Rs.2,00,000. Variable costs are 50% of Sales while fixed operating costs is Rs.60,000.
Interest on Long term loan amounted to Rs.20,000
Calculate the composite leverage.
Solution:
Sales 2,00,000
-Variable Costs[50%] (1,00,000)
-------------
Contribution 1,00,000
-Fixed Operating Costs (60,000)
----------
EBIT 40,000
-Interest (20,000)
----------
EBT 20,000
Combined Leverage= Contribution
--------------
EBT
=100,000
-----------
20,000
Combined Leverage = 5

II] Difference between Operating Leverage & Financial Leverage

Operating Leverage Financial Leverage

1.It is known as first stage leverage. 1. It is known as second stage leverage

2. It affects EBIT 2. It affects EBT & EAT

3.It relates to Asset Side of Balance 3. It relates to Liability Side of Balance

Sheet Sheet

4.It relates with Investment Decision 4. It relates with Financial Decision

5.It arises due to Fixed Operating 5.It arises due to Fixed Interest Expenses
Expenses of the co. of the co.

6.Operating Leverage= Contribution 6. Financial Leverage= EBIT

---------------- ----------------
EBIT EBT

7.Trading on Equity is not related . 7.Trading on Equity is related to

To Operating Leverage Financial Leverage[Favorable]

8.Tax Rate & Interest rate will not 8.Financial Leverage will change
Affect Operating Leverage due to Tax Rate & Interest Rate

III] Proforma Income Statement for Calculation of Leverages

Sales xx
-Variable Costs (x)
----
Contribution xx
-Fixed Costs[Excluding Interest] (x)
----
EBIT xx
-Interest on Borrowed Funds (x)
----
EBT xx
-Tax @ (x)
---
EAT xx
-Preference Dividend[If any] (x)
----
Profit Available for Equity Shareholders xx

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