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LEVERAGE

PARVESH AGHI

Meaning
The dictionary meaning of the term leverage refers to an increase means of accomplishing purpose. y In machines leverages means the instrument that helps us in lifting heavy objects, which may not be otherwise possible. y This concept is valid in business too. In Financial management ,it is used to describe the firms ability to use fixed assets costs to satisfy to magnify the returns of its owners
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Definition
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Leverage is the ratio of the net rate of return on the shareholders equity and net rate of return on total capiatlisation

Type of Leverage
There are three types of leverages 1. Financial leverage 2. Operating leverage 3. Composite leverage
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Financial leverage
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A firm needs funds to run and manage its activities. The funds are first needed to set a business and then to implement an expansion , diversification and other plans. A decision has to be made regarding the compositions of funds. The funds may be raised through two sources, owners , called owners equity and outsiders , called debt equity

Financial leverage exists whenever a firms has debts as sources of funds that carry a fixed charges

Computation of financial leverage


Where capital structure consists of equity shares and debts. y Financial leverage= EBIT EBT = EBIT EBIT-INT
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When capital structure consists of equity shares , preference shares and debt y FL= EBIT EBIT-INT-(PDX1/1-t)
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Degree of Financial leverage DFL


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DFL =

% change of EPS % change in EBIT

Operational Leverage
This leverage is associated with employment of fixed costs assets, it is calculated to know income of the company on different levels of sales. y It is a measure of effect on operating profit of the concern on change in sales
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Operational Leverage
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OL=

Contribution EBIT

Contribution= Sales variable cost EBIT = Contribution- fixed cost

Degree of operating leverage


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DOL=

%Change in EBIT % Change in Sales

Composite Leverage
Composite leverage is calculated to determine the combined effect of operating and financial leverage y CL= Financial Lev X Operating lev
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CL= EBIT X Contribution EBT EBIT = Contribution EBT


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Degree of Composite leverage


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DCL=

% Change in EBT % Change in Sales

Example
Calculate financial , operational and composite leverage from following data y Sales 1,00,000 units @2/- Per unit y Variable Cost per unit @.70 per unit y Fixed Cost Rs 1,00,000 y Interest charges on debt Rs 3668
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Sales Variable cost

1,00,000 1,00,000

2 .7

2,00,000 70,000

Contribution

1,30,000

Fixed Cost EBIT Interest EBT Financial lev EBIT/EBT 30000/26632

1,00,000 30,000 3368 26,632 1.126

Operational lev Composite

C/EBIT

1,30,000/30000

4.33

C/ EBT

1,30,000/26632

4.88

DFL DOL DCL %C in EBT/ %Cin Sales

FL= EBIT/EBT y OP=C/EBIT y CL= C/EBT


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