LEVERAGE ANALYSIS

LEVERAGE ANALYSIS
Leverage is the relationship between two integrated variables. In financial management
leverage reflects the responsiveness or influences of one financial variable over and other.
Operating Leverage:
It measures the relationship between sales volume and EBIT.

Degrees of operating leverage (D.O.L) = contribution / EBIT

Interpretation = change in EBIT / change in sales
PROBLEM NO: 1
Sales 1000 units @ Rs.10 per unit, variable cost Rs.4 per unit, Fixed cost
Rs.2, 000
Calculate the operating leverage and interpret the results?
If the sales are increased are decreased by 40%, what will be the increase or
decrease in EBIT?

SOLUTION:
Particulars Amount

Sales (1000 x 10) 10,000

Less: Variable cost (1000 x 4) 4,000

Contribution 6,000
Less: Fixed cost 2,000

EBIT 4,000
Degree of operating leverage (DOL) = C /EBIT = 6000/4000 =
1.5% or 1.5/1
Interpretation = change in EBIT / change in Sales = 1.5% / 1%
The change in 1% in sales will resulted in 1.5% of change in
EBIT.
Sales increased or decreased by 40%:

Particulars Increased by 40% Decreased by 40%

Sales 14,000 6,000

Less: Variable cost 5,600 2,400
Contribution 8,400 3,600
Less: Fixed cost 2,000 2,000
EBIT 6,400 1,600

DOL 8400/6400 = 1.31% 3600/1600 = 2.25%

Interpretation 1.31 / 1 2.25 / 1

 Sales increase by 40%,
EBIT should increase by 40 x 1.5 = 60%.
That is interpretation = change in EBIT/change in sales
= 1.5/1
1 = 40 40 x 1.5 = 60% sales = 1 EBIT = 1.5
1.5 =? 60% 40% ?

Cross check: EBIT is increased from 4,000 to 6,400 and

increased by B 2,400 = 2400/4000 x 100 = 60%

NOTE: operating leverage will be changed, if increase

or decrease in sales volume -- True
 Operating leverage arises due to the existence of fixed cost in cost structure. A
firm having high degree of operating leverage (DOL) can experience a substantial
change in sub-standard firm; a small drop in sales will drastically reduce EBIT.
Therefore a firm should avoid under high DOL. Since it is a high risk situation,
since small decrease in sales will reduce the profit substantially. Therefore a firm
should try to operate at level substantially higher than the chances of loss, when
the sales are minimized.
FINANCIAL LEVERAGE:
It measures the relationship between EBIT and EPS.
Degree of financial leverage (DFL), [when there is no preferential dividend] =
EBIT / EBT
DFL, [when there is preferential dividend] = EBIT / EBT – [Pref dividend / 1 – tax]
Interpretation = % of changes in EPS / % in changes of EBIT
PROBLEM NO:2
EBIT is Rs. 2,000, Interest Rs. 1,000, Tax rate 50%, No of Equity share = 100.
 SOLUTION: INCOME STATEMENT
Particulars Amount

EBIT 2,000
Less: Interest 1,000
EBT 1,000
Less: Tax @ 50% 5,00
EAT 5,00

No of Equity shares = 100.EPS = EAT / no of Equity shares = 500 / 100 = Rs. 5 per
share. DLF = [when there is no pref dividend] = EBIT /EBT = 2000 / 1000 = 2 / 1
Interpretation: % of changes in EPS / % of change in EBIT = 2 / 1.1% change in EBIT
will result in 2% change in EPS. Assume EBIT is increased by 50%:
EBIT is increased by 50%, then EPS increased by double = 50*2 = 100%
That is EBIT 50 x 1 = 50%; EPS 50 x 2 = 100%
Verification: EBIT EPS
1 2
50%100%
 Particulars Amount
EBIT [2000+50% of 2000] 3,000
Less: Interest 1,000
EBT 2,000
Less: Tax @ 50% 1,000
EAT 1,000

EPS = 1000/ 100 = Rs.10 per share DLF = EBIT / EBT = 3000 / 2000
=1.5 / 1. Interpretation = EPS / EBIT = 1.5 / 1. EPS is increased from Rs.5 to
Rs.10, that is 100% i.e., 5/5 x 100 = 100%
NOTE: Financial leverage arises due to the existence of debt with the
capital structure. Debt financing is suggested only when the firm has
prospects for financial leverage. For this the cost of debt is to be
compared with the ROI.

Favorable financial leverage will arise when the ROI is more than the
cost of Debt. The high financial leverage, bring in high return to
shareholders. At the same time exposing the company to high risk.
COMBINED LEVERAGE:
Operating leverage explains the business risk to shareholders and the financial leverage
indicates the financial risk of the firm. The total risk of the firm that is business + financial
risk is combined by combined leverage (CL).
Degree of Combined leverage (DCL) = DOL * DFL
OR
DCL [when there is no preference dividend] = Contribution / EBT
DCL [when there is preference dividend]= contribution/EBT–[Pref dividend / 1 – Tax]
Interpretation: % of changes in EPS / % of changes in sales.
CONCLUSION:
The firm hiring both operating leverage and financial leverage which are very high will
have wide fluctuations in the EPS for even a small change in sales left. To keep this risk
within management the firm has a high degree of operating leverage should keep alone
financial leverage and vice versa.
NOTE: It is a financial leverage which is within the management’s control. Since the interest
payment to which the firm is committed depends on the company’s financial policy.
• PROBLEM NO: 3

From the following details calculate leverages and

interpret the results.

Particulars A B C
Output(units) 60,000 15,000 1,00,000
Selling price 1 3 .50
per unit(Rs)
Fixed cost(Rs) 7,000 14,000 15,000
Variable cost .20 1.50 .02
per unit(Rs)
Interest(Rs) 4,000 8,000 10,000
Preference - - 5,000
dividend
Tax rate 50% 50% 50%
SOLUTION: INCOME STATEMENT
Particulars A(Rs) B(Rs) C(Rs)
Sales (unit*selling 60,000 45,000 50,000
price) 12,000 22,500 2,000
Less: Variable cost
(units*v c p u)
Contribution 48,000 22,500 48,000
Less: Fixed cost 7,000 14,000 15,000
EBIT 41,000 8,500 33,000
Less: Interest 4,000 8,000 10,000
EBT 37,000 500 23,000
Less: Tax @ 50% 18,500 250 11,500
EAT 18,500 250 11,500
Less: pref - - 5,000
dividend
Amount Available 18,500 250 6,500
to share holders
• COMPUTATION OF LEVERAGES:
Particulars A B C
O.L = contribution/EBIT 48000/41000 = 1.170 22500/8500 = 2.65 48000/33000 = 1.45
F.L = EBIT / EBT 41000/37000 = 1.11 8500 / 500 = 17 -
(When there is no pref divi)
F.L = EBIT/EBT-[Pref. Divi/1-tax] - - 33000/ 23000-[5000/1-.50] = 2.54
[When there is pref dividend]
Combined leverage 1.17 x 1.11 = 1.30 2.65 x 17 = 45.05 1.45 x 2.54 = 3.683
Or
DCL = EBIT / EBT 48000/37000=1.30 22500/500 = 45
48000 23000-[5000/1-.50 = 3.69
PROBLEM NO: 4
• A firm has sales of Rs.10, 00,000; variable cost RS.7, 00,000; Fixed cost
Rs.2, 00,000; it has a debt of Rs.5, 00,000(10%), Calculate leverages?
• If the firm wants to double the EBIT, what % would the sales changes?
• If the sales increase by 20%, by what % the EPS will be changed?
• If the firm wants to double the EPS, what % would the EBIT changed?
SOLUTION: INCOME STATEMENT:

Particulars Amount (Rs)

Sales 10,00,000
Less: variable cost 7,00,000
Contribution 3,00,000
Less: Fixed cost 2,00,000
EBIT 1,00,000
Less: Interest (5, 00,000 * 10%) 50,000
EBT 50,000
Less: Tax -
EBS 50,000
Operating leverage = contribution / EBIT = 3, 00,000 / 1, 00,000 =3 / 1
Financial leverage = EBIT / EBT = 1, 00,000 / 50,000 = 2 / 1
Combined leverage = OL x FL = 3 x 2 = 6 (or) Contribution / EBT = 3, 00,000 /
50,000 = 6.
If the firm wants to double the EBIT:
Interpretation of OL = change in EBIT / change in sales = 3/ 1
Sales EBIT
1% 3% 100% / 3 x 1 = 33 1/3% or 33.33%
? 100% Changes in sales = 33.33%
If the sales increased by 20%:
Combined leverage interpretation = % of change in EPS / % change in sales = 6/1
Sales EPS
1% 6% 20 x 6/1 =120%
20% ? EPS increased by 120%
IF THE FIRM WANTS TO DOUBLE THE EPS
If the firm wants to double the EPS:
Financial leverage interpretation = % change in EPS / % change in EBIT = 2/1
EBIT EPS
!% 2% 100 x 1/2 = 50%
? 100% change in EBIT = 50%
PROBLEM NO: 5

Variable expenses as a percentage of sales is 75%; interest

Rs.300; Operating leverage = 6; financial leverage = 4; tax rate =
50%. Prepare income statement?
SOLUTION: INCOME STATEMENT

Particulars Amount (Rs)

Sales 9,600
Less: variable cost 7,200
Contribution 2,400
Less: Fixed cost 2,000
EBIT 400
Less: Interest 300
EBT 100
Less: Tax 50
EAT 50
STEPS:1) Financial leverage = EBIT / EBT = 4/ 1
That is EBIT – EBT = Interest
4 -1 = 3
3 represents = Rs.300
4 represents = ?  400  EBIT
1 represents = ?  100  EBT

2) Operating leverage = contribution / EBIT =6 / 1

1 time EBIT represent = Rs.400
6 time contribution =? 6 x 400 = Rs.2, 400 or
Contribution – F.C = EBIT; 6 – 5 = 1; 2,400 – 2000 = 400

3) Sales – Variable cost = Contribution

100 – 75 =25 sales = 2,400 x 100/25 = Rs.9, 600
? - ? = 2,400 Variable cost = 2,400 x 75/25 = Rs.7, 200
PROBLEM NO: 6
Operating leverage = 2; combined leverage = 3; at present
sale level of 10,000 units; selling price = Rs.12; variable cost =
50% of sales; tax rate = 50%, the company has no of preference
share capital, if the rate of interest of the company’s debt is 16 %,
calculate the amount of debt to the capital structure?
SOLUTION: INCOME STATEMENT
Particulars Amount (Rs)
Sales (10000*12) 1,20,000
Less: variable cost(50% of sales) 60,000
Contribution 60,000
Less: Fixed cost 30,000
EBIT 30,000
Less: interest 10,000
EBT 20,000
Less: Tax @ 50% 10,000
EAT 10,000
O.L = contribution / EBIT = 2 / 1
2 times contribution = 60,000
1 time EBIT =? EBIT = 60000 x 1/2 = 30,000

C.L = contribution / EBT = 3 / 1

3 time contribution = 60,000
1 EBT =? EBT = 60000 x 1/3 = 20,000

DEBT: 16% = 10000

10,000 x 100/16
= Rs. 62,500
PROBLEM NO: 7
Selling price Rs.100; variable cost Rs.60 per unit; Fixed cost
Rs.40, 000; sales 1,200 units, What is the financial leverage of the
company if 10% change in sales will bring about, 90% change in
EPS; What percentage of increase in variable cost will result in
75% increase by the existing operating leverages?
SOLUTION: INCOME STATEMENT
Particulars Amount (Rs)
Sales 1,20,000
Less: variable cost 72,000
Contribution 48,000
Less: fixed cost 40,000
EBIT 8000
Financial leverage = EBIT / EBT
Interpretation = % change in EPS/%change in EBIT
OL = C / EBIT = 48000/8000 = 6%
Interpretation of CL = % change in EPS / % change in sales
= 90 / 10 = 9
Combined leverage = 9
CL =OL x FL; 9 = 6 x FL;
6FL = 9 i.e., Fl = 9/6 = 1.5
Existing OL = 6
(+) Increased 75% = 45 ( 75% on VC Rs. 60)Total New OL = 51 ie( 45 + 6 )
OL = Contribution / EBIT = 51/1
50 represents = 40000;
51 represents =?;
1 represents =?
Contribution = 40000 x 51/1 = Rs.40, 800;
EBIT = 40000 x 1/51 = 800
Particulars Amount (Rs)

Sales (1200 x 100) 1,20,000

Less: Variable cost 79,200
Contribution 40,800
Less: Fixed cost 40,000
EBIT 800

Variable cost is increased from Rs. 72,000 to 79,200 that is

increased by Rs. 7,200. Therefor the percentage of increase =
7,200/ 72,000 x 100 = 10%
PROBLEM NO: 8
Balance sheet of X Ltd:

Liabilities Rs. Assets Rs.

E.S. capital 60,000 Fixed asset 1,50,000

10% Debentures 80,000 Current Assets 50,000

Reserves 20,000    

Creditors 40,000    

Total 2,00,000 Total 2,00,000

 The company’s total asset turnover ratio is 3; fixed operating
expenses Rs.1, 00,000; variable cost ratio = 40%; Tax ratio = 35%;
calculate all leverages, EBIT if EPS isRs.3?

SOLUTION: INCOME STATEMENT

Particulars Amount (Rs)
Sales 6,00,000
Less: V.C (6, 00,000 x 40%) 2,40,000
Contribution 3,60,000
Less: Fixed Expenses 1,00,000
EBIT 2,60,000
Less: interest (80,000 x 10%) 8,000
EBT 2,52,000
Less: Tax @ 35% 88,200
EAT 1,63,800
1. Calculation of sales: Total Asset Ratio = sales / total asset = 3:1
Sales/2, 00,000 = 3:1
Sales = 2, 00,000 x 3 = Rs.6, 00,000
2. Operating leverage = contribution / EBIT = 3,60,000 / 2,60,000 = 1.38
3. Financial leverage = EBIT / EBT = 2,60,000 / 2,52,000 = 1.03
4. Combined leverage = OL x FL = 1.38 x 1.03 = 1.42
Computation of EBIT:
EPS = (EBIT – Interest) (1 – tax) / no of Equity shares)
3 = (x – 8000) (1 – .35) / 6000
3 = .65x -5200/6000
3*6000 = .65x – 5200. 18,000 = .65x – 5200. .65x = 23,200
X = 23,200 / .65 = Rs.35, 692 i.e. EBIT = Rs.35, 692.
PROBLEM NO: 9
Production = 20,000 units, selling price Rs.20 per unit; variable
cost Rs.15 p u; fixed cost Rs.40,000; Interest Rs.10,000;
Preference dividend Rs. 5000; no of equity share 10,000; Tax @
40%; calculate 1) all leverages, 2) operating, financial and overall
B.E.P?
SOLUTION: INCOME STATEMENT
Particulars Amount (Rs)
Sales (20,000*20) 4,00,000
Less: variable cost (20,000*15) 3,00,000
Contribution 1,00,000
Less: Fixed cost 40,000
EBIT 60,000
Less: Interest 10,000
EBT 50,000
Less: Tax (40%) 20,000
EAT 30,000
Less: pref dividend 5,000
Amount available for E.S.holders 25,000
 EPS = 25,000 / 10,000 = Rs. 2.50 per share.
Leverages:
OL = Contribution / EBIT = 1, 00,000 / 60,000 = 1.67
FL = EBIT / EBT-(pref. divi/ 1-Tax) = 60,000 / 50000 – (5000/1-.40)
= 60,000 / 41,667 = 1.44
CL = OL * FL = 1.67 x 1.44 = 2.40
Operating BEP:
It represents no of units to be sold and to cover fixed and variable
cost.
Operating BEP = Fixed cost / Contribution per unit
Contribution per unit = selling price – variable cost per unit;
C = 20 – 15 = 5. BEP = 40,000 / 5 = 8,000 units
 
Financial BEP (in Rs): it is a EBIT required to cover the interest and
Preference dividend
Formula = Interest + (preference dividend / 1 - Tax)
= 10,000 + 5000 / 1 - .40)
10,000 + 8,333 = Rs.18, 333
Financial BEP = Rs. 18,333
Overall BEP: It represents sales in unit required to cover fixed cost,
interest and preference dividend.
Overall BEP = Fixed cost + interest + (pref divi/ 1 – tax) /
contribution per unit
= 40,000+10,000+ (5000/1 - .40) / 5
= 40,000+10,000+8,333 / 5
=58,333 / 5
THANK YOU