Leverage Analysis

Learning Objectives
1) Meaning of Leverage and its relevance in
Corporate finance
2) Types of Leverages
3) Computation of Different leverages
4) Impact of Leverages on Risk
 Meaning of Leverage
The dictionary meaning of leverage is “ an increased means
of accomplishing the a goal or task”.

In Finance, Leverage refers to the use of an asset or

source of funds which involves fixed costs or fixed
returns. As a result, the earnings available to the
shareholders/owners are affected as also their risk.

There are three types of leverage, namely,

1) Operating Leverage
2) Financial Leverage
3) Combined or Total Leverage
The operating leverage is favorable when increase in
sales volume has a positive magnifying effect on EBIT.

It is unfavorable when a decrease in sales volume has a

negative magnifying effect on EBIT. Therefore, high DOL is
good when sales revenues are rising and bad when they
are falling.

The DOL is a measure of the business/operating risk of

the firm.
Operating risk is the risk of the firm not being able to
cover its fixed operating costs. The larger is the
magnitude of such costs, the larger is the volume of sales
required to recover them. Thus, the DOL depends on
fixed operating costs.
 Operating Leverage
Leverage associated with asset acquisition or
investment activities is referred to as the operating
leverage.
It 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.

Degree of operating leverage (DOL) is computed in

two ways:
1) Percentage change in EBIT/Percentage change in
sales and
2) (Sales – Variable costs)/EBIT.
Example
Find out operating leverage from the
following data:

Sales, Rs 50,000
Variable costs, 60 per cent
Fixed costs, Rs 12,000
 Financial Leverage
Financial leverage is related to the financing activities of a firm. It
results from the presence of fixed financial charges (such as interest
on debt and dividend on preference shares).

Since such financial expenses do not vary with the operating profits,
financial leverage is concerned with the effect of changes in EBIT on
the earnings available to equity-holders.

It is defined as the ability of a firm to use fixed financial charges to

magnify the effect of changes in EBIT on the earnings per share
(EPS).

Degree of Financial leverage is calculated in two ways –

1) DOL = EBIT / EBT

2) DOL = % Change in EPS / % Change in EBIT

Financial leverage involves the use of funds obtained at a fixed cost
in the hope of increasing the return to the equity-holders.

When a firm earns more on the assets purchased with the funds
than the fixed cost of their use, the financial leverage is favourable.

Unfavourable leverage occurs when the firm does not earn as

much as the funds cost.

High fixed financial costs increase the financial leverage and, thus,
financial risk.

The financial risk refers to the risk of the firm not being able to
cover its fixed financial costs. In case of default, the firm can be
technically forced into liquidation. The larger is the amount of fixed
financial costs, the larger is EBIT required to recover them. Thus,
the DFL depends on fixed financial costs.
Example

Find the financial leverage from the following data:

Net worth, Rs 25,00,000

Debt/Equity, 3:1
Interest rate, 12 per cent
Operating profit, Rs 20,00,000
 COMBINED OR TOTAL LEVERAGE
Combined leverage is the product of operating leverage
and financial leverage.

Total risk is the risk associated with combined leverage.

It is expressed as follows –

DCL = DOL X DFL

% changein EBIT % changein EPS % changein EPS

DCL  
% changein sales % changein EBIT % changein sales

Contributi
on EBIT Contributi on
DCL  
EIBT EBIT I EBIT I
 Problems
1) Jan 2008 – 7 b) – 15 Marks
Calculate (a) the operating leverage, (b) financial leverage and
(c) combined leverage from the following data under
situations I and II and financial plans, A and B.
Installed capacity, 4,000 units
Actual production and sales, 75 per cent of the capacity
Selling price, Rs 30 per unit
Variable cost, Rs 15 per unit
Suggest the better financial plan out of both situations.
2) June –July 2009 – 1 c) – 10 Marks

You are required to:

(i) calculate the operating, financial and combined leverage for the
two companies; and
(ii) comment on the relative risk position of the firms.
3) Skyline Software Ltd has appointed you as its finance manager. The comapny
wants to implement a project for which Rs 30 lakh is required to be raised from
the market as a means of financing the projet.
The following financing plans and options are at hand: (Number in thousands)

The expected EBIT of the project is Rs 3,00,000. Assuming

corporate tax to be 35 per cent and the face value of all the
shares and debentures to be Rs 100 each.
Which plan should be accepted by the company?
4)
5)
6)
7)

Also determine the degree of financial leverage associated with each plan assuming EBIT of
Rs 10,00,000.
8)