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Leverage The term leverage in general refers to the relationship between two interrelated variables. In financial analysis, leverage reflects the responsiveness of one financial variable over some other financial variable. Leverage = % change in dependent variable % change in independent variable

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TYPES OF LEVERAGE

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OPERATING LEVERAGE

The relationship between sales revenue and EBIT is defined as operating leverage

Operating Leverage refers to the firm s ability to use fixed operating costs to magnify the effect of changes in sales on its operating profits (EBIT) and results in more than a proportionate change () in EBIT with change in the sales revenue.

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Degree of Operating leverage Degree of operating leverage (DOL) is defined as the percentage change in the earnings before interest and tax relative to a given percentage change in sales Degree of operating leverage (DOL) is computed in two ways: DOL = % Change in EBIT % Change in Sales DOL = Sales Variable Cost EBIT

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Whenever, there is a change in the level of activity and Operating Leverage is to be found out, then use the formulaDOL = % Change in EBIT % Change in Sales But, whenever Operating Leverage is to be found out for the current level of activity then use the formula DOL = Contribution EBIT

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Importance and Significance of Operating leverage Operating leverage is very useful to the financial manager - It tells the impact of change in sales on the level of operating profits of the firm. - A firm having higher DOL can experience a magnified effect on the level of operating profits (EBIT) for even a small change in sales level. - However, the EBIT may disappear and give way to operating loss if there is a decline in sales.

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Questions
Calculate Degree of Operating leverage a) Contribution = Rs 10,000 EBIT = Rs 2,000 b) Contribution = Rs 20,000 Fixed Cost = Rs 15,000 c) Sales = Rs 1,00,000; Variable Cost = Rs 40,000, Fixed Costs = Rs 30,000 d) Sales units 10,000; Selling price per unit Rs 10, variable Cost = 60%, total operating cost 90% e) Sales units 1000 1500 Selling price per unit Rs 10 Rs 10 EBIT Rs 1500 Rs 4500 f) Sales units 2000 3000 Selling price per unit Rs 10 Rs 10 Total Operating cost Rs 17600 Rs 21600

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Financial leverage / Trading on Equity Financial leverage measures the relationship between EBIT and EPS. Financial leverage is defined as the ability of a firm to use fixed charge sources of funds such as debt and preference share capital along with owners equity in the capital structure to magnify the effect of changes in EBIT on the earnings per share (EPS).

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