Leverage 01

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Chapter 05 – Leverage
Leverage refers to the ability of a firm in employing long term funds having a fixed cost, to enhance
returns to the owners. In other words, leverage is the amount of debt that a firm uses to finance its
assets. A firm with a lot of debt in its capital structure is said to be highly levered. A firm with no debt is
said to be unlevered. The term Leverage in general refers to a relationship between two interrelated
variables. In financial analysis it represents the influence of one financial variable over some other
related financial variable. These financial variables may be costs, output, sales revenue, Earnings
Before Interest and Tax (EBIT), Earning per share (EPS) etc.
For example :
A company formed with an investment of $5 million from investors, the equity in the company is $5 million;
this is the money the company can use to operate. If the company uses debt financing by borrowing $20
million, it now has $25 million to invest in business operations and more opportunity to increase value for
shareholders. An automaker, for example, could borrow money to build a new factory. The new factory
would enable the automaker to increase the number of cars it produces and increase profits.
Types of Risks faced by common shareholders

Business Risk Financial Risk
It refers to the risk associated with the firm’s It refers to the additional risk placed on the firm’s
operations. It is the uncertainty about the future shareholders as a result of debt use i.e. the
operating income (EBIT), i.e. how well can the additional risk a shareholder bears when a
operating incomes be predicted? company uses debt in addition to equity financing.
Business risk can be measured by the standard Companies that issue more debt instruments
deviation of the Basic Earning Power ratio. would have higher financial risk than companies
financed mostly or entirely by equity.
2020 © | FINANCIAL MANAGEMENT [CA INTERMEDIATE / CS EXECUTIVE / CMA INTERMEDIATE]

Types of Leverage
There are three commonly used measures of leverage in financial analysis. These are:
1) Operating Leverage
2) Financial Leverage
3) Combined Leverage
Profitability Statement
Particulars ₹
Selling Price per unit xx
(-) Variable Cost per unit (xx)
Contribution per unit xx
(x) Total No. of Units xx
Total Contribution xx
(-) Fixed Cost (including Depreciation) (xx) Operating Leverage
Earnings/Profit before Interest & Tax (EBIT / PBIT) xx Combined Leverage
(-) Interest Expense (xx) Financial Leverage
Earnings / Profit before Tax (EBT / PBT) xx
(-) Tax Expense (xx)
Earnings / Profit After Tax (EAT / PAT) xx
(-) Preference Dividend (if any) (xx)
Net Profit attributable to Equity SHs’ (NPAESH) xx
(÷) No. of Equity Shares Outstanding xx
Earnings per share (EPS) xx
(x) Price-to-Earnings (PE) Ratio xx
Market Price per share (MPS) xx
(x) No. of Equity Shares Outstanding xx
Market Capitalization xx

Operating Leverage (OL)

Operating leverage (OL) may be defined as the
employment of an asset with a fixed cost in the
hope that sufficient revenue will be generated to
cover all the fixed and variable costs. The use of
assets for which a company pays a fixed cost is
called operating leverage. With fixed costs the
percentage change in profits accompanying a
change in volume is greater than the percentage
change in volume. The higher the turnover of operating assets, the greater will be the revenue in relation
to the fixed charge on those assets.
Operating leverage is a function of three factors:

(i) Amount of fixed cost
(ii) Variable contribution margin and
(iii) Volume of sales.
Contribution
Operating Leverage =
Earnings before Interest and Tax (EBIT)
Where,
- Contribution = Sales (-) Variable Cost
- EBIT = Sales (-) Variable Cost (-) Fixed Cost
Degree of Operating Leverage (DOL)

As discussed earlier, operating leverage may also be defined as “the firm’s ability to use fixed operating
cost to magnify the effects of changes in sales on its earnings before interest and taxes.”
∆ in EBIT)
% ∆ in EBIT EBIT
Degree of Operating Leverage = , or ∆ in Sales)
% ∆ in Sales
Sales
When Degree of Operating Leverage is more than one (1), operating leverage exists. More is the Degree
of OL higher is operating leverage. A positive Degree of OL / OL means that the firm is operating at
higher level than the break-even level and both sales and EBIT moves in the same direction. In case of
negative Degree of OL / OL firm operates at lower than the break-even and EBIT is negative.

Situation 1: No Fixed Cost

Particulars 20,000 units (₹) 30,000 units (₹)
Sales @ ₹ 10 per unit 2,00,000 3,00,000
(-) Variable cost @ ₹ 5 per unit (1,00,000) (1,50,000)
Total Contribution 1,00,000 1,50,000
(-) Fixed Cost (NIL) (NIL)
Earnings Before Interest & Tax (EBIT) 1,00,000 1,50,000
Contribution 1.00 1.00
EBIT
% ∆ in EBIT + 50%
Degree of Operating Leverage = = = 1.00
% ∆ in Sales + 50%
Situation 2: Positive Leverage (Fixed Cost = ₹ 50,000)

Sales @ ₹ 10 per unit 2,00,000 3,00,000
(-) Fixed Cost (50,000) (50,000)
Earnings Before Interest & Tax (EBIT) 50,000 1,00,000
Contribution 2.00 1.50
EBIT
% ∆ in EBIT + 100%
Degree of Operating Leverage = = = 2.00
% ∆ in Sales + 50%
Situation 3: When Fixed Cost = Contribution (i.e. EBIT = NIL)

Sales @ ₹ 10 per unit 2,00,000 3,00,000
(-) Fixed Cost (1,00,000) (1,00,000)
Earnings Before Interest & Tax (EBIT) NIL 50,000
Contribution NOT DEFINED 3.00
EBIT
% ∆ in EBIT +∞%
Degree of Operating Leverage = = = NOT DEFINED
% ∆ in Sales + 50%

Concept of Break-Even Point

Break-even analysis is a generally used method to study the Cost Volume Profit analysis. This technique
can be explained in two ways:
(i) It is concerned with computing the break-even point. At this point of production level and sales there
will be no profit and loss i.e. total cost is equal to total sales revenue.
(ii) This technique is used to determine the possible profit/loss at any given level of production or sales.
Total Fixed Cost

Break Even Point (in units) =
Contribution per unit
All Figures are assumed

Particulars Product X (₹) Product Y (₹)
Selling Price per unit 40.00 20.00
(-) Variable Cost per unit (20.00) (12.00)
Contribution per unit 20.00 8.00
(x) Total Number of units 1,000 1,000
Total Contribution 20,000 8,000
(-) Fixed Cost (15,000) (5,000)
Earnings before Interest and Tax (EBIT) 5,000 3,000
Fixed Cost
Thus, Break Even Point (units) = 750 units 625 units
Contribution per unit
Total Contribution
Operating Leverage = 4.00 2.67
EBIT
There is a relationship between Leverage and Break Even Point. Both are used for Profit Planning. In
brief, the relationship between Leverage, Break Even Point and Fixed Cost are as under:
Leverage Break Even Point
1. Firm With Leverage Higher Break Even Point
2. Firm Without Leverage Lower Break Even Point
Fixed Cost Operating Leverage

1. High Fixed Cost Higher Degree of Operating Leverage
2. Low Fixed Cost Lower Degree of Operating Leverage

Analysis & Interpretation of Operating Leverage

Sr. Situation Result
1 No Fixed Cost NO Operating Leverage
2 Higher Fixed Cost Higher Break-Even Point
3 Higher Operating Leverage than Break Even Level Positive Operating Leverage
4 Lower Operating Level than Break Even Level Negative Operating Leverage
Question 1:
A Company produces and sells 10,000 shirts. The selling price per shirt is ₹ 500. Variable cost is ₹ 200
per shirt and fixed operating cost is ₹ 25,00,000.
a) Calculate operating leverage.
b) Calculate Break Even Point (in units)
c) If sales are up by 10%, then what is the impact on EBIT?
Question 2: (Homework)
Sheetal Ltd. produces and sells 25,000 Blazers in a year. The selling price per Blazer is ₹ 10,000.
Variable cost is ₹ 6,000 per shirt and fixed operating cost is ₹ 7,50,00,000.
a) Calculate operating leverage.
b) Calculate Break Even Point (in units)
c) If units sold increase by 15% & the Selling Price per unit reduces by 10%, what is the impact on EBIT?
Question 3:
X Limited has estimated that for a new product, its break-even point is 20,000 units. If the item is sold
for ₹ 14 per unit and variable cost ₹ 9 per unit, calculate the degree of operating leverage for sales
volume 25,000 units and 30,000 units.
Question 4:
A company operates at a production level of 5,000 units. The contribution is ₹ 60 per unit, operating
leverage is 6 and combined leverage is 24. If tax rate is 30%, what would be its earnings after tax?
Question 5:
Calculate the operating leverage for each of the four firms A, B, C and D from the following price and
cost data:

Particulars Firms
A (₹) B (₹) C (₹) D (₹)
Sales Price per unit 20 32 50 70
Variable Cost per unit 6 16 20 15
Fixed Operating Cost 60,000 40,000 1,00,000 NIL
What calculations can you draw with respect to levels of fixed cost and the degree of operating leverage
result? Explain. Assume number of units sold is 5,000.
Hint:
The operating leverage exists only when there are fixed costs. In the case of firm D, there is no magnified
effect on the EBIT due to change in sales. A 20 per cent increase in sales has resulted in a 20 per cent
increase in EBIT. In the case of other firms, operating leverage exists. It is maximum in firm A, followed
by firm C and minimum in firm B. The interpretation of Degree of OL of 7 is that 1 per cent change in
sales results in 7 per cent change in EBIT level in the direction of the change of sales level of firm A.
Question 6:
The Sale revenue of TM Excellence Ltd. @ ₹ 20 per unit of output is ₹ 20 lakhs and contribution is ₹ 10
lakhs. At the present level of output, the DOL of the company is 2.5. The company does not have any
Preference Shares. The number of Equity Shares are 1 lakh. Applicable Corporate Income Tax rate is
50% and the rate of interest on Debt Capital is 16% p.a. What is the EPS (at sales revenue of ₹ 20
lakhs) and amount of Debt Capital of the company if a 25% decline in sales will wipe out EPS?
Question 7:
The following summarizes the percentage changes in operating income, percentage changes in
revenues, and betas for four pharmaceutical firms.
Firm Change in Revenue Change in Operating Income Beta
PQR Ltd. 27% 25% 1.00
RST Ltd. 25% 32% 1.15
TUV Ltd. 23% 36% 1.30
WXY Ltd. 21% 40% 1.40
You are Required to:
1) Calculate the degree of operating leverage for each of these firms. Comment also.
2) Use the operating leverage to explain why these firms have different betas.

Financial Leverage (FL)

Financial leverage (FL) maybe defined as ‘the use of funds with a fixed cost in order to increase earnings
per share.’ In other words, it is the use of company funds on which it pays a limited return. Financial
leverage involves the use of funds obtained at a fixed cost in the hope of increasing the return to common
stockholders.
Earnings before Interest and Tax (EBIT)
Financial Leverage =
Earnings before Tax (EBT)
Where,
- EBIT = Sales (-) Variable Cost (-) Fixed Cost
- EBT = EBIT (-) Interest Expense (i.e. Sales (-) Variable Cost (-) Fixed Cost (-) Interest
Expense)
Degree of Financial Leverage (DFL)

As discussed earlier, Degree of financial leverage is the ratio of the percentage increase in earnings
per share (EPS) to the percentage increase in earnings before interest and taxes (EBIT). Financial
Leverage (FL) is also defined as “the ability of a firm to use fixed financial charges to magnify the effect
of ∆s in EBIT on EPS.”
∆ in EPS$
% ∆ in EPS EPS
Degree of Financial Leverage = , or ∆ in EBIT$
% ∆ in EBIT
EBIT
When Degree of FL is more than one (1), financial leverage exists. More the Degree of FL, higher is
financial leverage. (+)ve Degree of FL/FL means the firm operates at a level higher than break-even
and EBIT & EPS moves in the same direction. (-)ve Degree of FL/FL indicates the firm is operating at
lower than break-even point and EPS is (-)ve.
Situation 1: No Fixed Interest Charges

Earnings Before Interest & Tax 1,00,000 1,50,000
(EBIT)
(-) Interest Expense (-) (-)
Earnings before Tax (EBT) 1,00,000 1,50,000
(-) Tax @ 50% (50,000) (75,000)
Earnings after Tax (EAT) 50,000 75,000

(÷) No. of Equity Shares outstanding 10,000 10,000

Earnings per share (EPS) 5.00 7.50
EBIT 1.00 time 1.00 time
EBT
% ∆ in EPS + 50%
Degree of Financial Leverage = = = 1.00 time
% ∆ in EBIT + 50%
Situation 2: Positive Financial Leverage (Fixed Interest Charges = ₹ 20,000)

(-) Interest Expense (20,000) (20,000)
Earnings before Tax (EBT) 80,000 1,30,000
(-) Tax @ 50% (40,000) (65,000)
Earnings after Tax (EAT) 40,000 65,000
Earnings per share (EPS) 4.00 6.50
EBIT 1.25 times 1.15 times
EBT
(₹ 6.50 (-) ₹ 4.00)

% ∆ in EPS )
Degree of Financial Leverage = = ₹ 4.00 = 1.25 times
% ∆ in EBIT + 50%
Situation 3: When Fixed Interest Charges = EBIT (i.e. EBT = NIL)

(-) Interest Expense (1,00,000) (1,00,000)
Earnings before Tax (EBT) - 50,000
(-) Tax @ 50% (-) (25,000)
Earnings after Tax (EAT) - 25,000
Earnings per share (EPS) - 2.50
EBIT NOT DEFINED 3.00 times
EBT
(₹ 2.50 (-) ₹ NIL)

% ∆ in EPS )
Degree of Financial Leverage = = NIL = NOT DEFINED
% ∆ in EBIT + 50%

Analysis & Interpretation of Financial Leverage

1 No Fixed Financial Cost NO Financial Leverage
2 Higher Fixed Financial Cost Higher Financial Leverage
3 When EBIT is higher than Financial Break-even Positive Financial Leverage
4 When EBIT is lower than Financial Break-even Negative Financial Leverage
Question 8:
Find out operating leverage from the following data:
→ Sales ₹ 50,000
→ Variable Costs 60%
→ Fixed Costs ₹ 12,000
Compute the financial leverage from the following data:

→ Net Worth ₹ 25,00,000
→ Debt/Equity 3:1
→ Interest Rate 12%
→ Operating Profit ₹ 20,00,000
Question 9:
The capital structure of the Shiva Ltd. consists of Equity Share Capital of ₹ 20,00,000 (Share of ₹ 100
per value) and ₹ 20,00,000 of 10% Debentures, sales increased by 20% from 2,00,000 units to 2,40,000
units, the selling price is ₹ 10 per unit; variable costs amount to ₹ 6 per unit and fixed expenses amount
to ₹ 4,00,000. The Income Tax rate is assumed to be 50%.
1) You are required to calculate the following:

a. The percentage increase in earnings per share;
b. Financial leverage at 2,00,000 units and 2,40,000 units;
c. Operating leverage at 2,00,000 units and 2,40,000 units.
2) Comment on the behaviour of operating and Financial leverages in relation to increase in production
from 2,00,000 units to 2,40,000 units.

Question 10:
Gudia Enterprises manufactures and sells a typical electronic toy. The selling price and variable cost
per toy are ₹ 20 and ₹ 10 respectively. Operating fixed costs amount to ₹ 5 lakhs. The interest expense
is ₹ 2.5 lakhs and Degree of Financial Leverage is 2. Find out Degree of Operating Leverage and Sales
volume respectively.

X Ltd. manufactures and sells an electronic toy. The selling price and variable cost per toy are ₹ 300
and ₹ 100 respectively. Operating Fixed costs amounts to ₹ 50,00,000. The Interest Expenses are ₹
10,00,000 and Degree of Financial Leverage is 3 times. Find out Degree of Operating Leverage and
Sales volume respectively.
Question 12:
From the following, prepare Income Statement of Company X, Y and Z. Briefly comment on each
company’s performance.
Particulars A B C
Financial Leverage 3:1 4:1 2:1
Interest ₹ 200 ₹ 300 ₹ 1,000
Operating Leverage 4:1 5:1 3:1
Variable Cost as a % of Sales 662/3% 75% 50%
Income Tax Rate 45% 45% 45%

From the following financial data of Company Arijit and Company Shreya, prepare their Income
Statements.
Particulars Company Arijit Company Shreya
Variable Cost 56,000 60% of Sales
Fixed Cost 20,000 ?
Interest Expense 12,000 9,000
Financial Leverage 5:1 ?
Operating Leverage ? 4:1
Income Tax Rate 30% 30%
Sales ? 1,05,000

Question 14:
The capital structure of JCPL ltd is as follows:
→ Equity Share Capital of ₹ 10 each ₹ 8,00,000
→ 10% Preference Share Capital of ₹ 10 each ₹ 5,00,000
→ 12% Debentures of ₹ 100 each ₹ 7,00,000
Additional Information:
→ Profit after Tax (Tax Rate = 30%) ₹ 2,80,000
→ Operating Expenses (including Depreciation = ₹ 96,800) being 1.50 times of EBIT
→ Equity Dividend Paid 15%
→ Market Price per Equity Share ₹ 23
Required:
a) Operating and Financial Leverage
b) Cover for Equity and Preference Dividends
c) Earnings Yield and Price-to-Earnings Ratio
d) The Net Fund Flow (Hint: Net PAT (+) Depreciation (-) Total Dividend)

Combined Leverage (CL)

Combined leverage maybe defined as the potential use of fixed costs, both operating and financial, which
magnifies the effect of sales volume change on the earning per share of the firm.
Combined Leverage = Operating Leverage (x) Financial Leverage

Contribution Earnings before Int and Tax (EBIT)
= (x)
Earnings before Int and Tax (EBIT) Earnings before Tax (EBT)
Degree of Combined Leverage (DCL)

As discussed earlier, Degree of combined leverage (DCL) is the ratio of percentage change in earning
per share to the percentage change in sales. It indicates the effect the sales changes will have on EPS.
Degree of CL = Degree of OL (x) Degree of FL

∆ in EPS)
% ∆ in EBIT % ∆ in EPS % ∆ in EPS
= (x) = = ∆ in Sales EPS
% ∆ in Sales % ∆ in EBIT % ∆ in Sales )Sales
Analysis & Interpretation of Combined Leverage

1 No Fixed Cost and No Financial Cost NO Combined Leverage
2 Higher Total Fixed Cost Higher Combined Leverage
3 When Sales are higher than Break-even Point Positive Combined Leverage
4 When Sales are lower than Break-even Point Negative Combined Leverage
Question 15:
The operating income of a textile firm amounts to ₹ 1,86,000. It pays 50% tax on its income. Its capital
structure consists of the following:
→ 14% Debentures ₹ 5,00,000
→ 15% Preference Shares ₹ 1,00,000
→ Equity Shares (₹ 100 each) ₹ 4,00,000
You are required to:

1) Determine the firm’s EPS.

2) Determine the percentage change in EPS associated with 30% change (both increase & decrease)
in EBIT.
3) Determine the degree of financial leverage at the current level of EBIT.
4) What additional data do you need to compute operating as well as combined leverage?
Question 16:
A firm’s details are as under:
→ Sales (@ ₹ 100 per unit) = ₹ 24,00,000
→ Variable Cost = 50%
→ Fixed Cost = ₹ 10,00,000
It has borrowed ₹ 10,00,000 @ 10% p.a. and its equity share capital is ₹ 10,00,000 (₹ 100 each). Calculate:
a) Operating Leverage, Financial Leverage, Combined Leverage & Return on Investment
b) If the sales increases by ₹ 6,00,000; what will the new EBIT?

A firm’s details are as under:
→ Sales (@ ₹ 500 per unit) = ₹ 40,00,000
→ Variable Cost = 40%
→ Fixed Cost = ₹ 15,00,000
It has borrowed ₹ 14,00,000 @ 12% p.a. and its equity share capital is ₹ 16,00,000 (₹ 10 each). Calculate:
Question 18:
Shabana Ltd.’s details are as under:
→ Sales (@ ₹ 1,000 per unit) = ₹ 1,40,00,000
→ Variable Cost = 47.75% of Selling Price per unit
→ Fixed Cost = ₹ 30,00,000
It has borrowed ₹ 1,00,00,000 @ 8% p.a. and its equity share capital is ₹ 50,00,000 (₹ 100 each).
Calculate:


c) If the selling price per unit increases to ₹ 1,100 per unit, what will the new EBIT? Would your answer
change if the increase in Selling Price per unit had no corresponding impact on the increase in the
Variable Cost per unit?
Question 19:
The following data have been extracted from the books of LM Ltd.:
→ Sales ₹ 100 lakhs
→ Interest payable per annum ₹ 10 lakhs
→ Operating leverage 1.20
→ Combined leverage 2.16
You are required to calculate:

1) The financial leverage
2) Fixed Cost
3) PV Ratio

The following details of RST Limited for the year ended 31March, 2006 are given below:
→ Operating leverage 1.40
→ Combined leverage 2.80
→ Fixed Cost (Excluding interest) ₹ 2.04 lakhs
→ Sales ₹ 30.00 lakhs
→ 12% Debentures of ₹ 100 each ₹ 21.25 lakhs
→ Equity Share Capital of ₹ 10 each ₹ 17.00 lakhs
→ Income tax rate 30 per cent

1) Financial Leverage
2) PV Ratio and EPS
3) If the company belongs to an industry, whose assets turnover is 1.5, does it have a high or low assets
leverage?
4) At what level of sales the Earning before Tax (EBT) of the company will be equal to zero?


The following summarizes the percentage changes in operating income, percentage changes in
revenues, and betas for four pharmaceutical firms.
Firm Change in Revenue Change in Operating Income Change in EPS
P Ltd. 27% 25% 30%
Q Ltd. 25% 32% 24%
R Ltd. 23% 36% 21%
S Ltd. 21% 40% 30%
You are Required to:

1) Calculate the degree of operating leverage for each of these firms.
2) Calculate the degree of combined leverage for each of these firms.

A firm has sales of ₹ 75,00,000 variable cost is 56% and fixed cost is ₹ 6,00,000. It has a debt of ₹
45,00,000 at 9% and equity of ₹ 55,00,000. You are required to interpret:
1) The firm’s ROI?
2) Does it have favourable financial leverage?
3) If the firm belongs to an industry whose capital turnover is 3, does it have a high or low capital
turnover?
4) The operating, financial and combined leverages of the firm?
5) If the sales is increased by 10% by what percentage EBIT will increase?
6) At what level of sales the EBT of the firm will be equal to zero?
7) If EBIT increases by 20%, by what percentage EBT will increase?
Question 23:
Suppose there are two firms with the same operating leverage, business risk, and probability distribution
of EBIT and only differ with respect to their use of debt (capital structure).
Firm U Firm L
No Debt ₹ 10,000 in 12% Debt
₹ 20,000 in Assets ₹ 20,000 in Assets
40% Tax Rate 40% Tax Rate

Other available details include:

Particulars Firm U – Economy Status Firm L – Economy Status
Bad Average Good Bad Average Good
Probability 0.25 0.50 0.25 0.25 0.50 0.25
EBIT ₹ 2,000 ₹ 3,000 ₹ 4,000 ₹ 2,000 ₹ 3,000 ₹ 4,000
Analyse the following situation & comment. Compare the 2 firms under each economy status on the basis
of:
a. EBIT to Total Assets Ratio
b. Return on Equity Ratio
c. Interest Coverage Ratio
Also state, expected values for both the firms for the above 3 ratios & calculate the expected Coefficient
σ
of Variation (i.e. x# ) for both the firms based on RoE.
Solution:
Profitability statement for both the firms:
Probability (P) 0.25 0.50 0.25 0.25 0.50 0.25
EBIT ₹ 2,000 ₹ 3,000 ₹ 4,000 ₹ 2,000 ₹ 3,000 ₹ 4,000
(-) Interest (-) (-) (-) (₹ 1,200) (₹ 1,200) (₹ 1,200)
EBT ₹ 2,000 ₹ 3,000 ₹ 4,000 ₹ 800 ₹ 1,800 ₹ 2,800
(-) Tax @ 40% (₹ 800) (₹ 1,200) (₹ 1,600) (₹ 320) (₹ 720) (₹ 1,120)
Net Income (NI) ₹ 1,200 ₹ 1,800 ₹ 2,400 ₹ 480 ₹ 1,080 ₹ 1,680
Expected Net Income (x") = ∑[NI (x) P] ₹ 1,800 ₹ 1,080
Comparison between the two firms

Probability (P) 0.25 0.50 0.25 0.25 0.50 0.25
Total Assets ₹ 20,000 ₹ 20,000 ₹ 20,000 ₹ 20,000 ₹ 20,000 ₹ 20,000
Net Worth = Total Assets (-) Ext Debt ₹ 20,000 ₹ 20,000 ₹ 20,000 ₹ 10,000 ₹ 10,000 ₹ 10,000
Net Income (NI) ₹ 1,200 ₹ 1,800 ₹ 2,400 ₹ 480 ₹ 1,080 ₹ 1,680

a. EBIT to Total Assets (TA) = EBIT/TA 10% 15% 20% 10% 15% 20%
b. Return on Equity = NI (÷) Net Worth 6% 9% 12% 4.80% 10.80% 16.80%
EBIT/
c. Interest Coverage Ratio = Interest ∞ ∞ ∞ 1.67% 2.50% 3.30%
Expected Value = ∑[Relevant Ratio (x) P]
a. EBIT to Total Assets 15.00% 15.00%
b. Return on Equity 9.00% 10.80%
c. Interest Coverage Ratio (ICR) ∞ 2.50 times
Calculation of Co-efficient of Variation

Probability (P) 0.25 0.50 0.25 0.25 0.50 0.25
Return on Equity (x) 6% 9% 12% 4.80% 10.80% 16.80%
+)
Expected Return on Equity (x 9% 9% 9% 10.80% 10.80% 10.80%
(x - x+ ) (3%) 0% 3% (6.00%) 0% 6.00%
(x - x+ )2 9% 0% 9% 36% 0% 36%
P(x - x+ )2 2.25% 0% 2.25% 9.00% 0% 9.00%
+ )2] = Variance
Total [i.e. ∑P(x - x 4.50% 18.00%
Thus, Standard Deviation = √Variance 2.1213% 4.2426%

σ
Thus, Coefficient of Variation = 0.24 0.39
x#
Thus, the effect of leverage on profitability and debt coverage can be seen from the above example.
For leverage to raise expected ROE, BEP must be greater than Kd i.e. BEP > Kd because if Kd > BEP,
then the interest expense will be higher than the operating income produced by debt-financed assets, so
leverage will depress income. As debt increases, ICR decreases because EBIT is unaffected by debt,
and interest expense increases (Int Exp = Kd).
Thus, it can be concluded that the basic earning power (BEP) is unaffected by financial leverage. Firm
L has higher expected ROE because BEP > Kd and it has much wider ROE (and EPS) swings because
of fixed interest charges. Its higher expected return is accompanied by higher risk.

Nehha Pendse Ltd. has the following balance sheet and income statement information:

Balance Sheet as on March 31

Liabilities ₹ Assets ₹
Equity Capital (₹ 10 each) 8,00,000 Net Fixed Assets 10,00,000
10% Debt 6,00,000 Current Asset 9,00,000
Retained Earnings 3,50,000
Current Liabilities 1,50,000
Total 19,00,000 19,00,000
Income Statement for the year ended March 31

Particulars ₹
Sales 3,40,000
(-) Operating Expenses (including depreciation of ₹ 60,000) (1,20,000)
EBIT 2,20,000
(-) Interest (60,000)
EBT 1,60,000
(-) Taxes (56,000)
Net Earnings (EAT) 1,04,000
You are required to:

a) Determine the degree of operating, financial and combined leverages at the current sales level, if all
operating expenses, other than depreciation, are variable costs.
b) If total assets remain at the same level, but sales (i) increase by 20 percent and (ii) decrease by 20
percent, what will be the earnings per share at the new sales level?

A company had the following Balance Sheet as on 31st March, 2018:
Liabilities ₹ in crores Assets ₹ in crores
Equity Share Capital (50 lakh shares of ₹ 10 each) 5.00 Fixed Assets (net) 12.50
Reserves and Surplus 1.00 Current Assets 7.50
15% Debentures 10.00
Current Liabilities 4.00
Total 20.00 20.00

Additional Information is available as under:

- Fixed Cost per annum (excluding Interest) = ₹ 4.00 crores
- Variable Operating Cost Ratio = 65%
- Total Assets Turnover Ratio = 2.50 times
- Income Tax Rate = 30%
Required: Calculate the following and comment on the company’s Earnings Per Share, Operating
Leverage, Financial Leverage and Combined Leverage.
Question 26:
A company had the following Balance Sheet as on 31st March, 2020:
Liabilities ₹ in crores Assets ₹ in crores
Equity Share Capital (1 crore shares of ₹ 10 each) 10.00 Fixed Assets (net) 25.00
Reserves and Surplus 2.00 Current Assets 15.00
15% Debentures 20.00
Current Liabilities 8.00
Total 40.00 40.00
Additional Information is available as under:

- Fixed Cost per annum (excluding Interest) = ₹ 8.00 crores
- Variable Operating Cost Ratio = 65%
- Total Assets Turnover Ratio = 2.50 times
- Income Tax Rate = 40%
Required:
1) Calculate the following and comment on the company’s Earnings Per Share, Operating Leverage,
Financial Leverage and Combined Leverage.
2) Calculate EBIT, if EPS is ₹ 1, ₹ 2 and ₹ 0 per share

The following information related to XL Co. Ltd. for the year ended 31st March, 2013 are available to
you.
→ Equity Share Capital of ₹ 10 each ₹ 25,00,000

→ 11% Bonds of ₹ 1,000 each ₹ 18,50,000

→ Sales ₹ 42,00,000
→ Fixed cost (excluding interest) ₹ 3,48,000
→ Financial leverage 1.39
→ Profit-Volume Ratio 25.55%
→ Income Tax Rate applicable 35%

1) Operating Leverage
2) Combined Leverage; and
3) Earnings per share
Question 28:
Calculate the operating leverage, financial leverage and combined leverage from the following data under
Situation I and II and Financial Plan A and B
- Installed Capacity = 4,000 units
- Actual Production & Sales = 75% of Capacity
- Selling Price = ₹ 30 per unit
- Variable Cost = ₹ 15 per unit
- Fixed Cost
o Under Situation I = ₹ 15,000
o Under Situation II = ₹ 20,000
The details relating to the Capital Structure of the two financial plans are as follows:
Particulars Plan A (₹) Plan B (₹)
Equity 10,000 15,000
Debt (Rate of Interest = 20%) 10,000 5,000
Total 20,000 20,000

Impact of few combinations of Operating & Financial Leverages

Sr. Operating Leverage Financial Leverage Combined Leverage
1 High (i.e. High Fixed High (i.e. High Level This combination is very risky i.e. having both
Cost Structure) of Debt Capital) high leverages. It shows that the firm is
employing excessive assets, for which it has to
pay fixed cost and simultaneously it is also
using large amount of debt capital. This
combination should normally be avoided
2 High (i.e. High Fixed Low (i.e. Low Level This situation is not advantageous to
Cost Structure) of Debt Capital) shareholders.
3 Low (i.e. Low Fixed High (i.e. High Level This situation does not take true advantage of
Cost Structure) of Debt Capital) debt financing to maximize return on the equity.
This is considered to be ideal situation for the
maximization of profit with minimum risk. Since,
operating leverage is low, full advantage of
debt financing can be taken to increase return
on equity.
4 Low (i.e. Low Fixed Low (i.e. Low Level This represents a situation in which
Cost Structure) of Debt Capital) management is making a cautious approach. It
is not possible for a company to maximize the
return to the shareholders in this type of
situation. This situation should be avoided.

Leverage 01

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CA Ankit Sarvaiya Coppergate Educare Page 60

Types of Risks faced by common shareholders

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Operating Leverage (OL)

Operating leverage is a function of three factors:

Degree of Operating Leverage (DOL)

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Situation 1: No Fixed Cost

Situation 2: Positive Leverage (Fixed Cost = ₹ 50,000)

Situation 3: When Fixed Cost = Contribution (i.e. EBIT = NIL)

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Concept of Break-Even Point

Total Fixed Cost

All Figures are assumed

Fixed Cost Operating Leverage

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Analysis & Interpretation of Operating Leverage

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Financial Leverage (FL)

Degree of Financial Leverage (DFL)

Situation 1: No Fixed Interest Charges

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(÷) No. of Equity Shares outstanding 10,000 10,000

Situation 2: Positive Financial Leverage (Fixed Interest Charges = ₹ 20,000)

(₹ 6.50 (-) ₹ 4.00)

Situation 3: When Fixed Interest Charges = EBIT (i.e. EBT = NIL)

(₹ 2.50 (-) ₹ NIL)

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Analysis & Interpretation of Financial Leverage

Compute the financial leverage from the following data:

1) You are required to calculate the following:

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Question 11: (Homework)

Question 13: (Homework)

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Combined Leverage (CL)

Combined Leverage = Operating Leverage (x) Financial Leverage

Degree of Combined Leverage (DCL)

Degree of CL = Degree of OL (x) Degree of FL

Analysis & Interpretation of Combined Leverage

You are required to:

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Question 17: (Homework)

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b) If the sales increases by ₹ 10,00,000; what will the new EBIT?

You are required to calculate:

Question 20: (Homework)

You are required to calculate:

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Question 21: (Homework)

You are Required to:

Question 22: (Homework)

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Other available details include:

Comparison between the two firms

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Calculation of Co-efficient of Variation

(x - x+ ) (3%) 0% 3% (6.00%) 0% 6.00%

P(x - x+ )2 2.25% 0% 2.25% 9.00% 0% 9.00%