USE OF LEVERAGE (OPERATIONAL & FINANCIAL)

A PROJECT REPORT

On

USE OF LEVERAGE (OPERATIONAL & FINANCIAL)

Submitted By

Ms Reema Marda
CS Regn No. 420659820/06/2009

In partial fulfilment of the Requirement of

Training under Company Secretary Course

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USE OF LEVERAGE (OPERATIONAL & FINANCIAL)

INDEX

S. Particular Page No.

No.
1 What is Leverage 3
2 Operating Leverage 4
3 Importance of Operating Leverage 5
4 Financial Leverage 6
5 Advantages of Financial Leverage 6-7
6 Difference between Operating and Financial Leverage 8

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USE OF LEVERAGE (OPERATIONAL & FINANCIAL)

WHAT IS LEVERAGE

In financial world, Leverage (also referred to as “Gearing” sometimes) is any technique used
to multiply business gains/profits.

Most often, it involves buying more of an asset by using borrowed funds, with the belief
that the Income from the asset or asset price appreciation will be more than the cost of
borrowing.

However, there remains always risk that borrowing costs may be larger than the income
from the asset or value of the asset may fall which may lead to huge losses.

Real Life Example

1. Individuals leverage their savings when buying a home by financing a portion of the
purchase price with mortgage debt.
2. Individuals leverage their exposure to financial investments by borrowing from their
broker.
3. Equity owners of businesses leverage their investment by having the business
borrow a portion of its needed financing. The more it borrows the less equity it
needs, so any profits or losses are shared among a smaller base and are
proportionately larger as a result. (Financial Leverage)
4. Businesses leverage their operations by using fixed cost inputs when revenues are
expected to be variable. An increase in revenue will result in a larger increase
in operating income (Operational Leverage)

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USE OF LEVERAGE (OPERATIONAL & FINANCIAL)

OPERATING LEVERAGE

Operating leverage measures a company’s fixed costs as a percentage of its total costs. It is
used to evaluate the break even point of a business, as well as the likely profit levels on
individual sales. The following two scenarios describe an organization having high operating
leverage and low operating leverage.

1. High operating leverage:

leverage A large proportion of the company’s costs are fixed costs.
In this case, the firm earns a large profit on each incremental sale, but must attain
sufficient sales volume to cover its substantial fixed costs. If it can do so, then the
entity will earn a major profit on all sales after it has paid for its fixed costs.

In other words, a Business that makes few sales, with each sale providing a very high
gross margin, is said to be highly leveraged.

2. Low operating leverage:

leverage A large proportion of the company’s sales are variable
costs, so it only incurs these costs if there is a sale. In this case, the firm earns a
smaller profit on each incremental sale, but does not have to generate much sales
volume in order to cover its lower
lower fixed costs. It is easier for this type of company to
earn a profit at low sales levels, but it does not earn outsized profits if it can
generate additional sales

In other words, a Business that makes many sales, with each sale contributing a very
slight
ght margin, is said to be less leveraged. As the volume

For example, a software company has substantial fixed costs in the form of developer
salaries, but has almost no variable costs associated with each incremental software sale;
this firm has high operating
rating leverage. Conversely, a consulting firm bills its clients by the
hour, and incurs variable costs in the form of consultant wages. This firm has low operating
leverage.

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USE OF LEVERAGE (OPERATIONAL & FINANCIAL)

IMPORTANCE OF OPERATING LEVERAGE

When using the operating leverage measurement, constant monitoring of operating

leverage is more important for a firm having high operating leverage, since a small
percentage change in sales can result in a dramatic increase (or decrease) in profits.

A business with high operating leverage benefits when sales go up because fixed costs
remain the same as revenues increase. The phrase "leveraging fixed costs” refers to getting
more production from the same fixed costs. Thus, a company with higher leverage
generates bigger profits during these periods. However, the company must pay those same
fixed costs even in a period of declining sales. Therefore, a company with higher operating
leverage will experience bigger losses when sales drop.

Knowledge of the level of operating leverage can have a profound impact on pricing policy,
since a company with a large amount of operating leverage must be careful not to set its
prices so low that it can never generate enough contribution margin to fully offset its fixed
costs.

Business Risk

The variance of a company’s operating profit is a measure of its business risk. Many factors
contribute to these fluctuations, including changing customer demand, pricing decisions, the
positioning of competitors, government regulation, worker productivity and the cost of
supplies. Some of these factors are external to the company, while others are the result of
management decisions. Operating leverage is one of the largest contributors to business risk
that management has the power to control.

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USE OF LEVERAGE (OPERATIONAL & FINANCIAL)

FINANCIAL LEVERAGE

Financial leverage can be defined as the degree to which a company uses fixed-income
fixed
securities, such as debt and preferred equity. With a high degree of financial leverage come
high interest payments. As a result, the bottom-line
line earnings per share is negatively affected
by interest payments. As interest payments increase as a result of increased financial
leverage, EPS is driven lower.

ADVANTAGES OF FINANCIAL LEVERAGE

Magnification of Shareholder Profits

If a company is solely financed by shareholder equity, then its profitability to the
shareholders will change in proportion to its own change in profitability. For example,
should profits increase by ten percent, the shareholders' dividends or share value will
increase by ten percent. If the firm is leveraged, then that increase in profitability of the
operation will not increase the payments needed to service the debt. Thus the excess profit
is all passed to the shareholders and will necessarily increase the value va of shares or
dividends to a greater degree than the increase in the operation's profitability.

Improvement in Credit Rating

A firm that successfully uses leverage demonstrates by its success that it can handle the
risks associated with carrying debt. This
This can become an important factor when additional
financing is needed. Not only will loans more likely be available, but they will be available at
more attractive interest rates. Like individuals, companies with solid financials, but little
credit history,, sometimes have trouble convincing lenders that they are deserving of a good
rate.

Capturing Economies of Scale

Some activities become more efficient when conducted on a larger scale. Industrial mass
production is an example of such an activity. Generally, larger production facilities incur a
lower unit cost to produce goods. Since it is advantageous to the company both to offer
many items for sale and to compete by offering the consumer a lower price, larger facilities

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USE OF LEVERAGE (OPERATIONAL & FINANCIAL)

are often better. If the firm cannot afford such a facility, borrowing may be the best
solution.

Increased Free Cash

By borrowing funds, the firm incurs a debt that must be paid. But, this debt is paid in small
installments over a relatively long period of time. This frees funds for more immediate use.
For example, if a company can afford a new factory, but will be left with negligible free cash,
it may be better to finance the factory and spend the cash on hand on inputs, labor or even
hold a significant portion as a reserve against unforeseen circumstances.

Favorable tax treatment

In many tax jurisdictions, interest expense is tax deductible, which reduces its net cost to
the borrower.

However, financial leverage also presents the possibility of disproportionate losses, since
the related amount of interest expense may overwhelm the borrower if it does not earn
sufficient returns to offset the interest expense. This is a particular problem when interest
rates rise or the returns from assets decline.

Financial leverage is an especially risky approach in a cyclical business, or one in which there
are low barriers to entry, since sales and profits are more likely to fluctuate considerably
from year to year, increasing the risk of bankruptcy over time. Conversely, financial leverage
may be an acceptable alternative when a company is located in an industry with steady
revenue levels, large cash reserves, and high barriers to entry, since operating conditions
are sufficiently steady to support a large amount of leverage with little downside.

There is usually a natural limitation on the amount of financial leverage, since lenders are
less likely to forward additional funds to a borrower that has already borrowed a large
amount of debt.

In short, financial leverage can earn outsized returns for shareholders, but also presents the
risk of outright bankruptcy if cash flows fall below expectations.

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DIFFERENCE BETWEEN OPERATING LEVERAGE AND FINANCIAL LEVERAGE

Though both are related to fixed payments either in the form of fixed operating costs or in
the form of fixed financial changes, they are not same. Mentioned in below Table are the
differences between operating and financial leverages:

S.NO. OPERATING LEVERAGE FINANCIAL LEVERAGE

1. It is concerned with investment
activities of the firm/business.
2. It is determined by the cost
structure of the firm.
3. It is the firm’s ability to use fixed
operating costs to magnify the
effects of changes in sales on its
earnings before interest and taxes.
4. The higher the proportion of fixed
operating costs to the total
operating costs in the cost structure
of a firm, the higher is the degree of
operating leverage.
5. Degree of operating leverage
enables us to measure the business
risk associated with the firm.
It is concerned with financing activities of
the firm/business.
It is determined by the capital structure of
the firm.
It is the firm’s ability to use fixed financial
charges to magnify the effects of changes in
EBIT on tis earnings per share.
The higher the proportion of fixed charges
bearing capital (Debentures, Preference
Shares etc)to total capital (debt + equity) in
the capital structure of a firm, the higher is
the degrees of financial leverage.
Degree of financial leverage enables us to
measure the degree of financial risk,
associated with the firm.

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