J. K. SHAH CLASSES INTER CA.
– FINANCIAL MANAGEMENT
CHAPTER 2 LEVERAGES
THEORY SECTION
Meaning and Scope
The term leverage, in general, refers to the relationship between two interrelated
variables of which one variable is dependent on the other.
Formula for calculating Leverage
% change in dependent variable
=
% change in independent variable
In this chapter we have to learn and calculate 3 leverages :
1. Operating Leverage
2. Financial Leverage
3. Combined Leverage
Operating Leverage
Income Statement for calculating Operating Leverage
Sales xx............. (independent)
Less: Variable Cost xx
Contribution xx
Less: Operating Fixed Cost xx
EBIT xx............. (dependent)
% change in EBIT
Operating Leverage =
% change in Sales / Contribution
OR
Contribution
Operating Leverage =
EBIT
Operating Leverage is a measure of operating risk. Operating risk comes into
existence due to presence of operating fixed cost (e g: Fixed salaries, rent, etc.)
Operating Leverage indicates the tendency of the EBIT to change disproportionately
due to change in sales. Operating Leverage of 1 indicates no operating risk. The
higher the operating leverage higher is the operating risk.
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J. K. SHAH CLASSES INTER CA. – FINANCIAL MANAGEMENT
Financial Leverage
Income statement for financial leverage
EBIT xx .........(independent)
Less: Interest xx
EBT xx
Less: Tax xx
EAT xx
Less: Preference dividend (1+DDT) (xx)
Earnings for equity shareholders xx...............(dependent)
:- No of equity shares xx
EPS xx..............(dependent)
% change in EPS / Earning for Equity shareholders
Financial Leverage =
% change in EBIT
OR
EBIT
Financial Leverage =
EBT - Preference dividend (1 + DDT)
(1 - tax rate)
Financial Leverage is a measure of financial risk and financial risk comes into
existence due to presence of fixed finance cost (e.g. interest, preference dividend). It
indicates the tendency of the EPS / Earnings for equity shareholders to change
disproportionately due to change in EBIT. FL of 1 indicates no financial risk. The
higher the financial leverage higher is the financial risk.
Combined Leverage
% change in EPS / Earnings for Equity shareholders
Combined Leverage =
% change in sales
OR
Contribution
Combined Leverage =
EBT - preference dividend (1 + DDT)
(1 - tax rate)
OR
Combined Leverage = Operating Leverage x Financial Leverage
It is a measure of total risk.
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J. K. SHAH CLASSES INTER CA. – FINANCIAL MANAGEMENT
CLASSWORK SECTION
Question 1
The data relating to two companies are as given below:
A Ltd. B Ltd.
Equity Capital ` 6,00,000 ` 3,50,000
12% Debentures ` 4,00,000 ` 6,50,000
Output (units) per annum 60,000 15,000
Selling price/ unit ` 30 ` 250
Fixed Costs per annum ` 7,00,000 ` 14,00,000
Variable Cost per unit ` 10 ` 75
You are required to calculate the Operating leverage, Financial leverage and
Combined leverage of two Companies.
Question 2
A firm’s details are as under:
Sales (@100 per unit) ` 24, 00,000
Variable Cost 50%
Fixed Cost ` 10, 00,000
It has borrowed ` 10, 00,000 @ 10% p.a. and its equity share capital is ` 10, 00,000
(` 100 each)
Calculate:
(a) Operating Leverage
(b) Financial Leverage
(c) Combined Leverage
Question 3
X Limited has estimated that for a new product its break-even point is 20,000 units if
the item is sold for ` 14 per unit and variable cost ` 9 per unit. Calculate the degree
of operating leverage for sales volume 25,000 units and 30,000 units.
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J. K. SHAH CLASSES INTER CA. – FINANCIAL MANAGEMENT
Question 4
A company had the following Balance Sheet as on 31st March, 2020:
Liabilities (` in crores) Assets (` in crores)
Equity Share Capital (50 5 Fixed Assets (Net) 12.5
lakhs shares of ` 10 each) Current Assets 7.5
Reserves and Surplus 1
15% Debentures 10
Current Liabilities 4
20 20
The additional information given is as under:
Fixed cost per annum (excluding interest) ` 4 crores
Variable operating cost ratio 65%
Total asset turnover ratio 2.5
Income Tax rate 30%
Required:
Calculate the following:
(i) Earnings Per Share
(ii) Operating Leverage
(iii) Financial Leverage
(iv) Combined Leverage
Question 5
The following details of RST Limited for the year ended 31st March, 2020 are given
below:
Operating leverage 1.4
Combined leverage 2.8
Fixed Cost (Excluding interest) ` 2,04 lakhs
Sales ` 30,00 lakhs
12% Debentures of ` 100 each ` 21,25 lakhs
Equity Share Capital of ` 10 each ` 17,00 lakhs
Income tax rate 30 per cent
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J. K. SHAH CLASSES INTER CA. – FINANCIAL MANAGEMENT
Required:
(i) Calculate Financial leverage
(ii) Calculate P/V ratio and Earning per Share (EPS)
(iii) If the company belongs to an industry, whose assets turnover is 1.5, does it
have a high or low assets turnover?
(iv) At what level of sales the Earning before Tax (EBT) of the company will be equal
to zero?
Question 6
A firm has sales of ` 75, 00,000 variable cost is 56% and fixed cost is ` 6, 00,000. It
has a debt of ` 45, 00,000 at 9% and equity of ` 55, 00,000.
(i) What is the firm’s ROI?
(ii) Does it have favourable financial leverage?
(iii) If the firm belongs to an industry whose capital turnover is 3, does it have a high
or low capital turnover?
(iv) What are the operating, financial and combined leverages of the firm?
(v) If the sales is increased by 10% by what percentage EBIT will increase?
(vi) At what level of sales the EBT of the firm will be equal to zero?
(vii) If EBIT increases by 20%, by what percentage EBT will increase?
Question 7
The operating income of a textile firm amounts to ` 1,86,000. It pays 50% tax on its
income. Its capital structure consists of the following:
14% Debentures ` 5,00,000
15% Preference Shares ` 1,00,000
Equity Shares (` 100 each) ` 4,00,000
(i) Determine the firm’s EPS
(ii) Determine the percentage change in EPS associated with 30% change (both
increase and decrease) in EBIT.
(iii) Determine the degree of financial leverage at the current level of EBIT.
(iv) What additional data do you need to compute operating as well as combined
leverage?
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J. K. SHAH CLASSES INTER CA. – FINANCIAL MANAGEMENT
Question 8
The Capital structure of RST Ltd. is as follows:
(`)
Equity Share of ` 10 each 8,00,000
10% Preference Share of ` 100 each 5,00,000
12% Debentures of ` 100 each 7,00,000
20,00,000
Additional Information:
Profit after tax (Tax Rate 30%) are ` 2, 80,000
Operating Expenses (including Depreciation ` 96,800) are 1.5 times of EBIT
Equity Dividend paid is 15%
Market price of Equity Share is ` 23
Calculate:
(i) Operating and Financial Leverage
(ii) Cover for preference and equity dividend
(iii) The Earning Yield Ratio and Price Earning Ratio
(iv) The Net Fund Flow
Question 9
The net sales of A Ltd. is ` 30 crores. Earnings before interest and tax of the company
as a percentage of net sales is 12%. The capital employed comprises ` 10 crores of
equity, ` 2 crores of 13% Cumulative Preference Share Capital and 15% Debentures
of ` 6 crores.
Income-tax rate is 40%.
(i) Calculate the Return-on-equity for the company and indicate its segments due
to the presence of Preference Share Capital and Borrowing (Debentures).
(ii) Calculate the Operating Leverage of the Company given that combined leverage
is 3.
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J. K. SHAH CLASSES INTER CA. – FINANCIAL MANAGEMENT
TO BE DISCUSSED ONLY IN CLASSROOM
Question 1
The following information related to XL Company Ltd. for the year ended 31st March,
2020 are available to you:
Equity share capital of ` 10 each ` 25 lakh
11% Bonds of ` 1000 each ` 18.5 lakh
Sales ` 42 lakh
Fixed cost (Excluding Interest) ` 3.48 lakh
Financial leverage 1.39
Profit-Volume Ratio 25.55%
Income Tax Rate Applicable 35%
You are required to calculate:
(i) Operating Leverage;
(ii) Combined Leverage; and
(iii) Earning per Share.
Question 2
Calculate the operating leverage, financial leverage and combined leverage from the
following data under Situation I and II and Financial Plan A and B:
Installed Capacity 4,000 units
Actual Production and Sales 75% of the Capacity
Selling Price ` 30 Per Unit
Variable Cost ` 15 Per Unit
Fixed Cost:
Under Situation I ` 15,000
Under Situation-II ` 20,000
Capital Structure:
Financial Plan
A (`) B (`)
Equity 10,000 15,000
Debt (Rate of Interest at 20%) 10,000 5,000
20,000 20,000
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J. K. SHAH CLASSES INTER CA. – FINANCIAL MANAGEMENT
HOMEWORK SECTION
Question 1
Annual sales of a company is ` 60, 00,000. Sales to variable cost ratio is 150 per cent
and Fixed cost other than interest is ` 5, 00,000 per annum. Company has 11 per cent
debentures of ` 30, 00,000.
You are required to calculate the operating, Financial and combined leverage of the
company.
Question 2
From the following financial data of Company A and Company B: Prepare their Income
Statements.
Company A (`) Company B (`)
Variable Cost 56,000 60% of Sales
Fixed Cost 20,000 -
Interest Expenses 12,000 9,000
Financial Leverage 5:1 -
Operating Leverage - 4:1
Income Tax Rate 30% 30%
Sales - 1,05,000
Question 3
Calculate the operating leverage, financial leverage and combined leverage for the
following firms and interpret the results:
P Q R
Output (units) 2,50,000 1,25,000 7,50,000
Fixed Cost (`) 5,00,000 2,50,000 10,00,000
Unit Variable Cost (`) 5 2 7.50
Unit Selling Price (`) 7.50 7 10.0
Interest Expense (`) 75,000 25,000 - 7,50,000
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J. K. SHAH CLASSES INTER CA. – FINANCIAL MANAGEMENT
Question 4
The capital structure of ABC Ltd. as at 31.3.20 consisted of ordinary share capital of `
5, 00,000 (face value ` 100 each) and 10% debentures of ` 5, 00,000 (` 100 each). In
the year ended with March 15, sales decreased from 60,000 units to 50,000 units.
During this year and in the previous year, the selling price was ` 12 per unit; variable
cost stood at ` 8 per unit and fixed expenses were at ` 1, 00,000 p.a. The income tax
rate was 30%.
You are required to calculate the following:
(i) The percentage of decrease in earnings per share.
(ii) The degree of operating leverage at 60,000 units and 50,000 units.
(iii) The degree of financial leverage at 60,000 units and 50,000 units.
Question 5
A firm has Sales of ` 40 lakhs; Variable cost of ` 25 lakhs; Fixed cost of ` 6 lakhs; 10%
debt of ` 30 lakhs; and Equity Capital of ` 45 lakhs.
Required:
Calculate operating and financial leverage.
Question 6
From the following details of X Ltd., prepare the Income Statement for the year ended
31st December, 2020:
Financial Leverage 2
Interest ` 2,000
Operating Leverage 3
Variable cost as a percentage of sales 75%
Income tax rate 30%
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