CAPITAL STRUCTURE

&
LEVERAGE
 LEVERAGE
 Leverage refers to an increased means of accomplishing some
purpose which are otherwise not possible
 Leverage means the instrument that helps us in lifting heavy
objects, which may not be otherwise possible. This concept of
leverage is valid in business too.
 Leverage is the strategy of using borrowed money to increase
return on an investment.
 If the return on the total fund invested in the business
(owner’s fund plus borrowed funds) is higher than the interest
to be paid on the borrowed funds, business can make
significant profit.
 Leverage is the employment of an asset or sources of funds for
which the firm has to pay a fixed cost or fixed return.
 LEVERAGE
 The fixed cost funds i.e. debentures & preference share capital
act as the fulcrum, which assist the lever, i.e. the firm to lift i.e.
to increase the earnings of its owner i.e. the equity
shareholders.

-Firm
 LEVERAGE
 In financial management, it is the firm’s ability to use
fixed cost assets or funds to increase the returns to its
owners.
 If earnings less the variable costs exceed the fixed costs
i.e. preference dividend & interest on debenture, or
earnings before interest and taxes exceed the fixed
return requirement, the leverage is called favorable .
when they do not ,the result is unfavorable leverage .
 Leverage is also the influence which an
independent variable has over a dependent/related
variable. For ex. rainfall over production. In financial
context, sales & fixed cost over profit.
 Income Statement
 Sales xxxxx
 Less: Variable cost - xxxx

 Contribution xxxx

 Less: Fixed cost - xxx

 EBIT xxxx
 Less interest xxx
 EBT xxxx

 Less Tax xxx

 EAT xxxx

 Less preference dividend xxxx

 Earnings for shareholders xxxx

 EPS = Earnings for Shareholders / No. of Equity Shares

 CONCEPT OF LEVERAGE
 Leverage refers to relationship between two inter-related variables.
 It reflects influence of one financial variable over other financial variable.
For e.g. variables in business are costs, sales, EBIT,EPS, output etc.
 Ex- Increase of sales promotion on sales revenue
 Leverage = % change in dependent variable
% change independent variable

Sales EBIT
- Variable cost - Interest
= Contribution = Profit before Tax
- Fixed cost - Tax
= EBIT = Profit After Tax EAT
= EAT/ No. of Shares= EPS
 The relationship between Sales and EBIT is Operating Leverage
 The relationship between EBIT and EPS is Financial Leverage
 TYPES OF LEVERAGE
 There are three types of leverages-

 1 . Financial leverage

 2 . Operating leverage

 3 . Combined leverage
 FINANCIAL LEVERAGE
 A firm needs funds to run and manage its activities. The
funds are first needed to set up an enterprise and then to
implement expansion, diversification and other plans.
 A decision has to be made regarding the composition
of funds. The funds may be raised through two sources:
owners, called owners equity, and outsiders, called
creditors fund.
 “Financial leverage exists whenever a firm has debts
and other sources of funds that carry fixed charges.”
.
 FINANCIAL LEVERAGE OR
TRADING ON EQUITY
 The use of long term fixed cost bearing funds
like debt and preference share capital along
with the equity share capital is called financial
leverage or trading on equity
 A firm is known to have a favorable leverage if
its earnings are more than what debt would
cost. On the contrary, if it does not earn as much
as the debt costs then it will be known as an
unfavorable leverage.
FINANCIAL LEVERAGE
 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 earnings per share.

 In other words, 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
on equity shares
 FINANCIAL LEVERAGE

 The use of the sources of funds with fixed-charges,

such as debt and preference capital along with the
owners’ equity in the capital structure, is described as
financial leverage or gearing or trading on equity.
 The financial leverage employed by a company is
intended to earn more return on the fixed-charge
funds than their costs. The surplus (or deficit) will
increase (or decrease) the return on the owners’ equity.
The rate of return on the owners’ equity is levered above
or below the rate of return on total assets.
Example of Trading on Equity

 Able Company has an Equity capital of 1000 shares of

Rs.100/- each fully paid & earns an average profits of
Rs.30,000 annually.
 Now it wants to make an expansion & needs another
Rs.1,00,000. The company can either issue new shares or
raise loans @ 10%p.a{Assuming same rate of profit}.
 It is advisable to raise loans as by doing so earnings per
share will magnify.
 The company shall pay only Rs.10,000 as interest &
profit expected shall be Rs.60,000[EBIT].
 Profits left for shareholders[EBT] shall be Rs.50,000. It
is 50% return on the equity capital against 30% return
otherwise.
MEASURES OF FINANCIAL
LEVERAGE
 Debt ratio
 Debt–equity ratio
 Interest coverage
 The first two measures of financial leverage can be
expressed either in terms of book values or market
values. These two measures are also known as measures
of capital gearing.
 The third measure of financial leverage, commonly
known as coverage ratio. The reciprocal of interest
coverage is a measure of the firm’s income gearing.
 DEBT-TO-EQUITY RATIO

Debt–to– Total Liabilities

Equity Ratio = Stockholders’ Equity

This ratio indicates the relative proportions of debt

to equity on a company’s balance sheet.

Stockholders prefer debt if Creditors prefer less debt

the company can take and more equity because
advantage of positive equity represents a buffer
financial leverage. of protection.
 DEBT SERVICE COVERAGE RATIO (DSCR)
DSCR or
No. of Times Interest = Earnings before Interest and Taxes
Covered by Earnings Interest Expense

This is the most common measure of a

company’s ability to provide protection
for its long-term creditors. A ratio of
less than 1.0 is inadequate.
 FINANCIAL LEVERAGE
 Financial leverage results from the difference between
the rate of return the company earns on investments
in its own assets and the rate of interest that the
company must pay its creditors.
o On the contrary, if the firm acquires fixed cost funds
at a higher cost than the earnings from those assets,
then the EPS and return on equity capital will
decrease.

Return on Fixed rate of Negative

investment in assets< return on = financial
borrowed funds leverage
 COMPUTATION OF FINANCIAL
LEVERAGE
 Computation of financial leverage Where capital structure consists
of equity shares and debts:
o As, Leverage = % change in dependent variable
% change independent variable

 Degree of financial leverage- DFL :

 DFL = % change in EPS

% change in EBIT or NOP
NOP = Net Operating Profit

 FL = EBIT
EBT
IMPACT OF FINANCIAL LEVERAGE
 When the difference between the earnings from assets,
financed by fixed cost funds, and cost of these funds,
( EBIT-I) i.e. EAT are distributed to the equity
stockholders, they will get additional earnings without
increasing their own investment. Consequently the EPS
and the Rate of return on Equity Share Capital will go
up.
 It is also known as trading on equity.


Fixed rate of
Return on return on Positive
investment in > borrowed funds = financial
assets leverage
 SIGNIFICANCE OF FINANCIAL LEVERAGE
 Planning of capital structure
 Profit planning
 Associated with financing activities

Implications of Financial Leverage

 Helpful to know how EPS would change with a change in
operating profit
 Helps in measuring financial risk

Limitations of FL/ trading on equity

 Double-edged weapon
 Beneficial only to companies having stability in earnings
 Increases risk and rate of interest
 Restriction from financial instruments
 OPERATING LEVERAGE (OL)
 Operating leverage results from the presence of fixed
costs that help in magnifying net operating income
fluctuations flowing from small variations in revenue.
 The changes in sales are related to changes in the revenue.
The fixed costs do not change with the changes in sales,
any increase in sales, Fixed Cost remaining the same, will
magnify operating revenue.
 OL shows the ability of a firm to use fixed operating cost
to increase the effect of change in sales and the change in
operating income.
 OPERATING LEVERAGE (OL)
 The Operating Leverage is associated with investment (asset
acquisition) activities

 Operating Leverage= Contribution = C

Operating Profit EBIT
where, Contribution= Sales-Variable cost
EBIT/Operating Profit= Sales-Variable cost-Fixed cost

 Operating leverage is also defined as the ratio of the

percentage change in operating income for a given percentage
change in sales.

 DOL= % change in EBIT or operating income

% change in Sales
IMPLICATIONS OF OPERATING LEVERAGE (OL)

 Helps in knowing how operating income will change with change in

sales.

 The risk associated with operating leverage is called operating risk .

It is the risk of not being able to cover fixed operating costs by firm

 As Operating leverage is associated with the employment of fixed

cost assets, it is calculated to know income of the company on
different levels of sales.

 “Operating leverage is the tendency of the operating profit to vary

with the change in sales.” .
 Difference in Operating & Financial Leverage
S.Basis OPERATING FINANCIAL
no LEVERAGE LEVERAGE
.
1. Objective Magnifies the effect of Magnifies the effect of
changes in sales volume on changes in EBIT on EPS.
operating profit.
2. Relationship Establishes relationship b/w Establishes relationship b/w
EBIT & Sales. EBIT & EPS
.
3. Measurement Measures a firm’s ability to Measures a firm’s ability to
use fixed cost assets to use fixed cost funds to
magnify the operating profits. magnify the return to equity
shareholders
4. Decision Concerned with investment Concerned with financing or
decision. capital structure decision.
5. Risk Involves the operating risk Involves the financial risk
of being unable to cover being unable to cover fixed
fixed operating costs. financial cost i.e., interest.
6. Relates Liabilities side of balance
Assets side of balance sheet.
sheet.
 COMBINED LEVERAGE -CL
 The OL affects the income which is the result of production.
On the other hand, FL is the result of financial decisions. The
CL focuses attention on the entire income of the concern

 This leverage shows the relationship between a change in sales

and the corresponding variation in taxable income.

 Working capital leverage

 This leverage measures the sensitivity of ROI of changes in the

level of current assets.

CL: = FL X OL = C or % change in EPS

EBT % change in sales
Computation of Leverages

FL: = EBIT or % change in EPS

EBT % change in EBIT

OL: = C or % change in income

EBIT % change in sales

CL: = FL X OL = C or % change in EPS

EBT % change in sales
 Effects of Debt on ROA and ROE

 ROA is lowered by debt

 Interest expense lowers net income, which also lowers
ROA.
 However, the use of debt lowers equity, and if equity
is lowered more than net income, ROE would
increase.
 Example
1 : A company has sales of ₹15,00,000; variable costs is 40% of sales; fixed
cost ₹1,00,000 and 12%debentures of ₹ 7,00,000. Calculate the operating,
financial & combined leverage.

i). Operating Leverage = 𝐶𝑜 𝑛 𝑡 𝑟 𝑖 𝑏 𝑢 𝑡 𝑖 𝑜 𝑛 = ₹ 9,00,000

=1.125
𝐸𝐵𝐼𝑇
ii). Financial Leverage = 𝐸𝐵𝐼 𝑇
₹=8,00,000
₹ 8,00,000
= 1.12
𝐸𝐵𝑇
₹ 7,16,000
iii). Combined leverage = 𝑐 𝑜 𝑛 𝑡 𝑟 𝑖 𝑏 𝑢 𝑡 𝑖 𝑜 𝐸𝐵𝐼𝑇
𝐸𝐵𝐼𝑇 ×
𝑛

𝐸𝐵𝑇
= 1.25
₹ 9, 00 , 000 ₹ 8, 00 ,
OR = × Sale = ₹15,00,00
C 𝑜 𝑛 𝑡 𝑟 𝑖 𝑏 𝑢 𝑡 𝑖 � 000 -Variable cost =0- ₹ 6,00,000
₹ 9,00,000
�𝑛 = = 1.25 =Contribution = ₹ 9,00,000
𝐸𝐵𝑇 ₹ 8,00,000
₹ 7,16,000 ₹ 7,16,000 -Fixed cost = - ₹ 1,00,000
= EBIT = ₹ 8,00,000
- Interest = - ₹ 84,000
= EBT =
₹7,16,,000
 Exercise on Leverage
Q. 1. Calculate the degree of operating leverage, degree of financial leverage and the
degree of combined leverage for the following firms and interpret the results :
P Q R
Output (units) 2,50,000 1,25,000 7,50,000
Fixed Cost 5,00,000 2,50,000 10,00,000
Unit Variable Cost 5 2 7.50
Unit Selling Price 7.50 7 10.0
Interest Expenses 75,000 25,000 ---

Q. 2. The following data relate to RT Ltd. :

• Earnings before interest and tax (EBIT) 10,00,000
• Fixed Cost 20,00,000
• Earnings Before Tax (EBT) 8,00,000
• Required : Calculate combined leverage.
 Exercise on Leverage

Q. 3. X Ltd. 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).
• The company is in a tax bracket of 50%.

• Calculate : (a) Operating Leverage

• (b) Financial Leverage
• (c) Combined Leverage
• (d) Return on Equity
• (e) If the sales increases by ₹ 6,00,000 ;
what will the new EBIT ?