YOUTUBE CHANNEL-ACCOUNTS WITH CHIRAG

BY-CHIRAG SIR (NET, CA/CS FINAL, MCOM (ABST)

Whatsapp no. 7014049781 Gmail: - chiragca1991@gmail.com Instagram chirag.luv

Concept of leverage
In mechanics the leverage concept is used for a technique by which more weight is raised with less power. In
financial management the leverage is there where is fixed cost. If any firm is using some part of fixed cost capital
then the firm has leverage which can be used for raising profitability and financial strength of the firm.

It is used in the sense that a slight change in sales results in a relatively higher change in profits. It is possible
only when fixed cost of capital is used along with equity capital. That is why, when a business enterprises employ
fixed cost bearing funds along with owner funds in the regular conduct of business, it is said that business is using
leverage to increase its profits.

According to Guthman and Dougull, “Leverage means a fixed cost or paying a fixed return for employed funds.
There are two types of leverage:
1. Operating Leverage 2. Financial Leverage

1. OPERATING LEVERAGE
Operating leverage occurs when a firm incurs fixed costs which are to be recovered out of sales revenue
irrespective of the volume of business in a period. In a firm having fixed costs in the total cost structure, a given
change in sales will result in disproportionate change in the operating profit or EBIT of the firm. According to E.W.
Walked and J.w. Patty, “Operating leverage is defined as the use of fixed operating costs to magnify a change in
profits relative to a given change in sales.

Characteristics of Operating Leverage

1. Related to fixed operating costs

2. Highest operating leverage near break-even point
3. On the one side the operating leverage raises operating profits but on the other side it raises business
risks of increasing losses. Because if operating leverage is high a small fall in sales will result in a big fall in
operating profit. It deals with business risk, unavoidable risk and uncontrollable risk.

Formula of Operating Leverage

= or

If the contribution is larger than fixed cost it will be favourable and if it is smaller than it would be unfavourable
operating leverage.

Degree of Operating Leverage – It can be computed on the basis of results of two levels of sales.

DOL =

Question- Current level of sales: 6000 units and Break-even point sales 4000 units. What would be the DOL?

(A) 1.50 (B) 0.67 (C) 3.00 (D) None of the above
 2. FINANCIAL LEVERAGE

In a firm’s capital structure there can be two types of capital namely fixed cost capital and variable cost capital. So
if there is fixed cost capital then financial leverage will be present. It may be defined as the ability of the firm to
use fixed cost of capital to magnify the effect of changes in operating profit or EBIT.

According to Gitman, “Ability of a firm to use fixed financial charges to magnify the effects of changes in EBIT on
the firms earning per share is financial leverage.”

Characteristics of Financial Leverage

1. Related to fixed cost capital

2. Related with liabilities side of balance sheet where different type of sources of capital are shown.
3. Shows effects of changes in fixed charges on EPS of the firm
4. Financial risk of the firm increases with the presence of financial leverage. With the increase in EBIT
(operating profit) EPS increases proportionately more on account of financial leverage and likewise EPS
declines more rapidly than decline in EBIT (operating profit). It deals with financial risk, avoidable risk and
controllable risk.

If the proportion of fixed cost capital is high it will have a high financial leverage (Trading on equity) and if the
proportion of variable cost capital is high, there will be low financial leverage. The firm should use more of fixed
cost capital if the rate of earnings in the firm is higher than the cost of debt capital and if earnings rate is low, the
firm should use more of equity capital.

If the cost of borrowed funds is less than the overall return of funds, it will be favourable financial leverage and
otherwise it will be unfavourable i.e. if the overall return is less than the cost of borrowed capital.

Computation of Financial Leverage

DFL = or or

Degree of Financial Leverage-

Or

3. COMBINED/COMPOSITE LEVERAGE (Super leverage)

A leverage computed with the combined effects of fixed operating costs and fixed financial costs is known as
combined leverage.

Competitive firms choose high level of degree of combined leverage whereas conservative firms choose lower
level of degree of combined leverage. By using OL and FL, a small change in sales is magnified into a larger
change in earning per share.
Computation of Combined Leverage

= or Operating Leverage X Financial Leverage

Degree of Combined Leverage-

= or Degree of FL X Degree of OL

Example-

Ravina Ltd is producing and selling 50,000 units at present. Other information’s are as follows:
70,000 Equity Shares of Rs. 10 each Rs. 7, 00,000
10,000 10% Debentures of Rs. 100 each Rs. 10, 00,000
Selling price of the product Rs. 20 per unit
Fixed Operating Cost Rs. 2, 00,000 per year
Variable Operating Costs Rs. 10 per unit
The rate of income tax for the company is 30%

1. Calculate OL, FL and CL in existing situation

2. Calculate Degree of OL, FL and CL if sales increase to 60000 unit and decrease to 40000 unit

Particulars Existing Situation Situation 1 (60000) Situation 2 (40000)

Sales @ Rs. 20 per unit 10, 00,000 12, 00,000 8, 00,000

Less: variable cost @ Rs. 10 per unit 5, 00,000 6, 00,000 4, 00,000

Contribution 5, 00,000 6, 00,000 4, 00,000

Less: Fixed Costs 2, 00,000 2, 00,000 2, 00,000

EBIT 3, 00,000 4, 00,000 2, 00,000

Less: Interest 1, 00,000 1, 00,000 1, 00,000

EBT 2, 00,000 3, 00,000 1, 00,000

Less: Income tax @ 30% 60,000 90,000 30,000

EAT 1, 40,000 2, 10,000 70,000

Divide by: no. of equity share 70,000 70,000 70,000

EPS 2 3 1
In Existing Situation:-

Operating leverage = = = 1.67

Finance leverage = = = 1.5

Combined leverage = = = 2.5 Or OL X FL = 1.67 X 1.5 =2.5

Degree of OL, FL and CL

If sales increase to 60000 units

DOL = DFL = DCL=

= = =

= 1.67(Fav.) = 1.5(Fav.) = 2.5(Fav.)

If sales Decrease to 40000 Units

Same calculations as above but answer will be in unfavourable form.