Module 5

Leverages

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Concept - Leverages

● From the financial management point of view, leverage is commonly used to describe
the firm’s ability to use fixed cost assets or sources of funds to magnify the returns to
its owners.
● According to James Home, leverage is the ‘employment of an asset or sources of
funds for which the firm has to pay a fixed cost or fixed return.

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Types of Leverages

● Operating Leverage: Operating leverage is present anytime in a firm when it has operating
(fixed) cost regardless of the level of production. These fixed costs do not vary with sales, they
must be paid regardless of the amount of revenue available.
● The degree of operating leverage may be defined as the change in the percentage of
operating income (EBIT) for a given percentage of sales revenue.
Thus it measures the degree to which a firm or project can increase operating income by
increasing revenue

● Operating leverage = Contribution/Operating Profit (EBIT)

(Contribution = Sales –VC, Operating Profit=Sales-VC-FC)
● Degree of Operating leverage = Percentage change in EBIT/Percentage change in Sales

● A company is said to have a high degree of operating leverage if it employs a great amount of
fixed cost and smaller amount of variable cost.

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Uses of Operating Leverage

● Operating leverage is one of the techniques to measure the impact of changes in

sales which lead for change in the profits of the company.
● Operating leverage helps to identify the position of fixed cost and variable cost
● Operating leverage measures the relationship between the sales and revenue of the
company during a particular period.
● Operating leverage helps to understand the level of fixed cost which is invested in the
operating expenses of business activities.
● Operating leverage describes the overall position of the fixed operating cost

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Income Statement

Particulars Amount (Rs)

Sales ***
-Variable cost ***
Contribution ***
-Fixed Cost ***
EBIT / Operating Profit ***
-Interest expenses ***
EBT ***
-Tax @ given rate on EBT ***
EAT/Net Income ***
- Preference dividend @ dividend rate ***
Earnings Available to Equity Share holders ***
(EAESH)
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Question

XYZ Ltd produced and sold 1,00,000 units of a product at Rs. 10. For production
of 1,00,000 units; it had spent variable cost of Rs. 6,00,000 at the rate of Rs.
6 per unit and a fixed cost of Rs. 2,50,000. The firm has paid interest of Rs.
5,000 at the rate of 5% and Rs. 1,00,000 debt. Calculate Operating Leverage.

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Answer
Particulars Amount (Rs)

Sales Revenue (1,00,000 * 10) 10,00,000

Less Variable Cost (1,00,000 * 6) 6,00,000

CONTRIBUTION 4,00,000

Less Fixed Cost 2,50,000

EBIT 1,50,000

Operating Leverage = C/EBIT = 4,00,000/1,50,000 = 2.66 times.

An increase in sales of 10% will lead to an increase in profits by 26.6% and similarly
Decrease in sales of 10% will lead to losses by 26.6%

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Question

● From the following particulars, calculate degree of operating leverage:

Particulars Previous Year (2018) Current Year (2019)

Sales Revenue 10,00,000 12,50,000

Variable Cost 6,00,000 7,50,000

Fixed Cost 2,50,000 2,50,000

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Solution

Particulars 2018 2019 % change

Sales Revenue 10,00,000 12,50,000 25
Less Variable Cost 6,00,000 7,50,000 25
CONTRIBUTION 4,00,000 5,00,000 25
Less Fixed Cost 2,50,000 2,50,000
EBIT 1,50,000 2,50,000 66.67

Percentage change = Increase in the given variable/previous or base year

Degree of Operating Leverage = % change in EBIT/% change in sales
= 66.67/25 = 2.667 times

Operating Leverage of 2.667 indicates that when there is 25 percent change in sales,
the change in EBIT is 2.667 times.

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Operating Leverage

● A company with high operating leverage has a high percentage of fixed

costs to total costs, which means more units have to be sold to cover costs.

● A higher proportion of fixed costs in the production process means that

the operating leverage is higher and the company has more business risk.

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Question

From the following information of the firm, fixed cost = Rs. 50,000, Variable Cost
= 70% of sales, Sales = Rs. 2,00,000 in the previous year and R. 2,50,000 in
current year. Find out percentage change in sales and operating profit when:
i) Fixed costs are not there (no leverage)
ii) Fixed costs are there

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Solution

i) Particulars Previous year Current year Percentage

change
Sales 2,00,000 2,50,000 25%
Less Variable Cost 1,40,000 1,75,000 25%
Profit from 60,000 75,000 25%
Operations

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Solution
Particulars Previous Year Current Year Percentage
ii) Change
Sales 2,00,000 2,50,000 25%

Less Variable 1,40,000 1,75,000 25%

Cost
Contribution 60,000 75,000 25%

Less Fixed Cost 50,000 50,000

PROFIT FROM 10,000 25,000 150%

OPERATIONS

In Situation i) where there are no fixed costs (absence of leverage), the

percentage change in operating profit is the same i.e. 25%, In situation ii)
where there are fixed costs, the percentage change in profits (150%) is
much more than the percentage change in sales (25%).
The fixed cost element has helped in magnifying the percentage increase
in operating profits. It is true that a highly leveraged situation will magnify
the operating profits but it brings in risk element too.

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Question

Following information is taken from the records of a company:

Installed capacity – 1,000 units
Operating capacity – 800 units
SP Per unit – Rs. 10
VC per unit – Rs. 7

Calculate operating leverage, BEP, Margin of Safety under the following

situations:
Fixed Cost – Situation A = Rs. 800, Situation B = Rs. 1,200, Situation C = Rs.
1500

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Solution

Particulars Situation A Situation B Situation C

Sales (800*10) 8,000 8,000 8,000
Less Variable Cost 5,600 5,600 5,600
CONTRIBUTION 2,400 2,400 2,400
Less Fixed Cost 800 1,200 1,500
OPERATING 1,600 1,200 900
PROFIT
OPERATING 1.5 2 2.67
LEVERAGE (C/OP)
BEP (F/C * S) 2,667 4,000 5,000
M/S Ratio (OP/C) 66.7% 50% 37.5%
% of sales at BEP 33.33% 50% 62.5%

A high operating leverage (Situation C) has low margin of safety and thin cushion for
absorbing shocks whereas a situation of low operating leverage (situation A) has higher
M/S Ratio. Though, a highly leveraged situation brings in more profits with the increase
in sales, but at the same time it brings in more risk too.

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Interpretation

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Practice Questions

1) Find the Operating Leverage from the following:

Sales Rs. 5,00,000, Variable cost 60%, Fixed cost Rs. 1,20,000 (Answer – 2.5)

2) The following data are available: SP Per unit – Rs. 120, VC Per Unit – Rs. 70,
Fixed Cost – Rs. 2,00,000. a) What is the operating leverage when X Ltd.
Produces and sells 6,000 units? ( answer – 3) b) What is the percentage
change that will occur in the EBIT of the company if output increases by 5%
(15%)

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Financial Leverage

As we all know, firms may need long-term funds for long-term activities like
expansion, diversification, modernisation etc. The use of fixed charges,
sources of funds, such as debt and preference share capital along with the
equity share capital in capital structure is described as ‘financial leverage.’

According to Lawrence, financial leverage is the ability of the firm to use fixed
financial charges to magnify the effects of changes in EBIT on the firm’s EPS.
Financial leverage may be defined as the payment of fixed rate of interest for the
use of fixed interest bearing securities to magnify the rate of return for equity
shares. It is also known as ‘trading on equity.’

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Financial Leverage

● Financial Leverage = EBIT(Operating profit)/EBT(Taxable Income)

● Degree of FL = % change in EPS/% change in EBIT

Financial leverage may be positive or negative, favourable leverage occurs

when the firm earns more on the assets purchased with the funds than the
cost of their use and vice versa. Higher the degree of financial leverage,
higher the financial risk. Hence, financial manager should take into
consideration the level of EBIT and fixed charges while preparing the firm’s
financial plan.

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Financial Leverage

● Financial leverage helps to know how EPS would change with a change in
Operating profit.

● Basically, the higher the amount of debt a company uses as leverage, the
higher - and the riskier - is its financial leverage position. Also, the
more leveraged debt a company absorbs, the higher the interest rate burden,
which represents a financial risk to companies and their shareholders.

● However, the aim of financial leverage is to increase the revenue available for
equity shareholders using the fixed cost funds. If the revenue earned by
employing fixed cost funds is more their cost (interest/preference dividend)
then it will benefit the equity shareholders.

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Financial Leverage

A firm is said to have a favourable leverage if its earnings are more than what
debt would cost. On the contrary, if it does not earn as much the debt costs,
then it is said to have an unfavourable leverage.

Every firm has to make its own decision regarding the quantum of funds to be
borrowed. When the amount of debt is relatively large in relation to the capital
stock, a company is said to be ‘trading on equity.’

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Question

A firm has sales of Rs. 1,00,000 units at Rs. 10 per unit. Variable cost of the
produced products is 60% of the total sales revenue. Fixed cost is Rs.
2,00,000. The firm has used a debt of Rs. 5,00,000 at 20% interest. Calculate
the Operating Leverage and Financial Leverage.

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Solution

Particulars Amount (Rs.)

Sales Revenue (1,00,000 * 10) 10,00,000

Less Variable Cost (10,00,000*0.6) 6,00,000

CONTRIBUTION 4,00,000

Less Fixed Cost 2,00,000

EBIT (Operating Profit) 2,00,000

Less Interest (5,00,000*20%) 1,00,000

EBT 1,00,000

Operating Leverage = C/EBIT = 4,00,000/2,00,000 = 2 times

Financial Leverage = EBIT/EBT = 2,00,000/1,00,000 = 2 times

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Question

● From the following particulars of PQR company, calculate operating and

financial leverages. The company’s current sales revenue is Rs. 15,00,000
lakhs and sales are expected to increase by 25%. Rs. 9,00,000 is incurred on
variable expenses for generating Rs. 15 lakhs sales revenue. The fixed cost
is Rs. 2,50,000. The company has Rs. 20 lakhs equity share capital and Rs.
20 lakhs, 10% debt capital. Rs. 10 is the cost per equity share and 50% is the
tax rate.

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Solution
Particulars Current Position Expected Change % of change
(Rs) (Rs)
Sales Revenue 15,00,000 18,75,000 25
Less Variable Cost 9,00,000 11,25,000

CONTRIBUTION 6,00,000 7,50,000

Less Fixed Cost 2,50,000 2,50,000

EBIT 3,50,000 5,00,000 42.86

Less Interest @ 10% 2,00,000 2,00,000

EBT 1,50,000 3,00,000

Less Tax 50% 75,000 1,50,000

EAT 75,000 1,50,000

Less Preference -- ---

Dividend
EAESH 75,000 1,50,000

EPS 0.375 0.75

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Solution

● Working notes:
○ VC in % of sales = Total VC/Sales * 100 = 9,00,000/15,00,000 * 100 = 60%
○ Increase in VC = 18,75,000 * 60% = Rs. 2,25,000
○ Total VC = 9,00,000 + 2,25,000 = Rs. 11,25,000

% change in EBIT = Increase in EBIT/Base EBIT = 1,50,000/3,50,000 * 100 = 42.86%

Interest on debt = Rs. 20 lakhs * 10 % = Rs. 2,00,000

EPS = 75,000/2,00,000 = 0.375, 1,50,000/2,00,000 = 0.75

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Solution

Operating Leverage = Contribution/EBIT or % change in EBIT/% change in sales

= 6,00,000/3,50,000 or 42.86/25 = 1.74 times

Financial Leverage = EBIT/EBT or % change in EPS/% change in EBIT

= 3,50,000/1,50,000 0r 100/42.86 = 2.33 times

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Question

A firm is considering two financial plans with a view to examine their impact on
Earnings Per Share (EPS). The total funds required for investment in assets
are Rs. 5,00,000
Particulars Financial Plan I Financial Plan II
Debt (Interest @ 10% p.a.) 4,00,000 1,00,000

Equity Shares (Rs. 10 each) 1,00,000 4,00,000

Total finances required 5,00,000 5,00,000

Number of Equity Shares 10,000 40,000

The EBIT are assumed to be Rs. 50,000, Rs. 75,000 and Rs. 1,25,000. The
rate of tax is 50%. Comment on the leverage

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Solution
When EBIT is Rs. 50,000

Particulars Plan I Plan II

EBIT 50,000 50,000

Less Interest on Debt 40,000 10,000

EBT 10,000 40,000

Less Tax @ 50% 5,000 20,000

Earnings after Interest 5,000 20,000

and Tax
Number of Equity 10,000 40,000
Shares
EPS 5,000/10,000 = 0.5 20,000/40,000 = 0.5

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Solution (Contd..)
When EBIT is Rs. 75,000

Particulars Plan I Plan II

EBIT 75,000 75,000

Less Interest on Debt 40,000 10,000

EBT 35,000 65,000

Less Tax @ 50% 17,500 32,500

Earnings after Interest 17,500 32,500

and Tax
Number of Equity 10,000 40,000
Shares
EPS 17,500/10,000 = 1.75 32,500/40,000 = 0.81

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Solution (Contd..)
When EBIT is Rs. 1.25,000

Particulars Plan I Plan II

EBIT 1,25,000 1,25,000

Less Interest on Debt 40,000 10,000

EBT 85,000 1,15,000

Less Tax @ 50% 42,500 57,500

Earnings after Interest 42,500 57,500

and Tax
Number of Equity 10,000 40,000
Shares
EPS 42,500/10,000 = 4.25 57,500/40,000 = 1.438

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Solution (Contd..)

Plan I is a leveraged financial plan because it has 80% debt financing and has
only 20% equity financing. Plan II is a conservative financial plan where fixed
cost are only 20% of total funds and the rest is financing through equity
capital.
The EPS is increasing in Plan I with the increase in EBIT. In situation 1, the EPS
is same in both the plans. As the EBIT has increased from Rs. 50,000 to Rs.
75,000 (Situation 2) , the EPS in plan I is Rs. 1.75 while it is Rs. 0.81 in plan
II. EPS is Rs. 4.25 in plan I and Rs. 1.438 in plan II when EBIT increases to
Rs. 1,25,000. It is clear from the analysis that EPS is increasing with the
increase in profits in plan I as compared to plan II. This is possible with the
use of more fixed cost funds in plan I as compared to plan II. The increase in
EPS in plan I is due to the financial leverage because EBIT is same in all the
situations.

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Question

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Solution

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Solution

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Uses of financial leverage

● Financial leverage helps to examine the relationship between EBIT and EPS
● Financial leverage measures the percentage of change in taxable income to the
percentage change in EBIT.
● Financial leverage locates the correct profitable financial decision regarding capital
structure of the company.
● Financial leverage is one of the important devices which is used to measure the fixed
cost proportion with the total capital of the company.
● If the firm acquires fixed cost funds at a higher cost, then the earnings from those
assets, the earning per share and return on equity capital will decrease.

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Difference between Operating and Financial Leverage

Basis for
Operating Leverage Financial Leverage
Comparison

Use of debt in a company's

Use of such assets in the
capital structure for which it
company's operations for which
Meaning has to pay interest expenses
it has to pay fixed costs is
is known as Financial
known as Operating Leverage.
Leverage.

Measures Effect of Fixed operating costs. Effect of Interest expenses

Relates to Sales and EBIT EBIT and EPS

Ascertained by Company's Cost Structure Company's Capital Structure

High, only when ROCE is

Preferable Low
higher

Formula DOL = Contribution / EBIT DFL = EBIT / EBT

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Composite/Combined Leverage

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Question

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Solution

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