Skip to content

COMMERCEIETS
STUDY TO ENLIGHTEN YOURSELF

 BCOM GNDU NOTES – SCORE BEST IN YOUR EXAMS!!!

 MANAGEMENT ACCOUNTING NOTES
 BUSINESS ORGANISATION
 DIRECT TAX LAWS
 INTERNATIONAL BUSINESS
 INDUSTRIAL AND LABOUR LAWS
 OPERATIONS RESEARCH
 RISK MANAGEMENT AND INSURANCE
 BUSINESS STATISTICS
 PARTNERSHIP ACCOUNTS
 CORPORATE ACCOUNTING
 COMMERCIAL LAW
 MANAGERIAL ECONOMICS
 BUSINESS MANAGEMENT
 11 ACCOUNTANCY
 GOODS AND SERVICE TAX
 MICRO ECONOMICS
 12 ACCOUNTANCY
 KEY DIFFERENCES
 COST ACCOUNTING
 FINANCIAL ACCOUNTING
 FINANCIAL MANAGEMENT
 Toggle search form

3 TYPES OF LEVERAGE IN FINANCIAL

MANAGEMENT – OPERATING, FINANCIAL AND
COMBINED LEVERAGE
Posted onNovember 9, 2022 BycommerceietsNo Commentson 3 TYPES OF LEVERAGE
IN FINANCIAL MANAGEMENT – OPERATING, FINANCIAL AND COMBINED LEVERAGE

TYPES OF LEVERAGE IN FINANCIAL MANAGEMENT –

OPERATING, FINANCIAL AND COMBINED LEVERAGE

LEVERAGE
Leverage refers to debt or to the borrowings of funds to finance the purchase
of the company’s asset. It is used to measure the effect of increase or
decrease of fixed cost on the earnings.

Leverage may be
TYPES OF LEVERAGE IN FINANCIAL MANAGEMENT
ACCORDING TO THE JAMES HORNE: “Leverage can be defined as the
employment of an asset or funds for which the firm pays a fixed cost or fixed
return.”

TYPES OF LEVERAGE
The following are the types of leverages:

TYPES OF LEVERAGE IN FINANCIAL MANAGEMENT

FINANCIAL LEVERAGE OR TRADING

ON EQUITY
Financial leverage may be expressed when the residual net income (earnings
after interest and taxes and preference dividend) varies not in proportion with
operating profit. This leverage reveals the changes in the taxable income in
comparison with the changes in the operations.

In other words, a major part is played by the interest on debt financing,

interest on debentures, preference dividend in the entire capital structure of
the firm.
TYPES OF LEVERAGE IN FINANCIAL MANAGEMENT
The firm may be called as high levered if it has more use of debt and less
levered if it has less use of the debt.

Types of financial leverage: The financial leverage are of two types:

Favourable financial leverage: When the EPS (earning per share) increases
as an impact of debt financing in the corporate structure, it is called favourable
leverage.

Unfavourable financial leverage: When the EPS (earnings per share)

decreases as an impact of debt financing in the corporate capital structure, it
is called unfavourable financial leverage.

DEGREE OF FINANCIAL LEVERAGE:

The degree of financial leverage is the percentage change in taxable profit as
a result of percentage change in the operating profit i.e. the ability of the firm
to utilize financial charges in order to magnify the effect of changes in EBIT on
EPS of the firm.
TYPES OF LEVERAGE IN FINANCIAL MANAGEMENT
EPS= Earnings per share

EBIT= Earnings before interest and tax

DFL= Degree of financial leverage

Example: 10,000 equity shares @ ₹10 each= ₹1,00,000

10%; 500 debentures of ₹100 crores= ₹50,000

EBIT= 40,000; Find DFL

Answer: DFL= EBIT/ EBIT-I

= 40,000/ 40,000-5,000

= 40,000/ 35,000

= 1.14

Interest= 50,000*10%

TRADING ON EQUITY:
Sometimes ‘financial leverage’ is called ‘Trading on equity’. This is a device by
which the equity shareholders enjoy large amount of profit at the cost of other
fixed interest-bearing securities.
The rate of dividend of the equity shares can substantially be increased by the
issue of more debentures and preference shares with the fixed rate of interest
and the dividend.

Example: Suppose, the total requirement of the capital of the company is

₹20,00,000 and the expected rate of return on the capital is 12%. If the entire
capital consists of the equity shares only, there will be no Trading on equity,
but will simply be a return @12% on ₹20,00,000 by way of the dividends.

Now, suppose the capital structure of the company is:

10% debentures= ₹8,00,000

85 Preference shares= ₹4,00,000

Rate of return= 12%

Profit= 20,00,000*12%= ₹2,40,000

Profit 2,40,000

Less: Debentures Interest (80,000)

Less: Preference dividend (32,000)

1,28,000
Balance available for equity dividend= ₹1,28,000

Percentage of return on equity capital= (1,28,000/ 8,00,000) *100= 16%

So by the issue of the debentures and preference shares, trading on equity is

possible and as a result the rate of equity dividend increased from 12% to
16%.

EFFECT OF FINANCIAL LEVERAGE ON EPS

 EPS will increase if Return on Investment is more than the cost of the
debt.
 EPS will decrease if the return on investment is less than the cost of the
debt.

EFFECT OF FINANCIAL LEVERAGE ON FINANCIAL RISK

 High degree of financial Low degree of financial
leverage leverage

Variability in shareholder’s
Increases Decreases
earnings

Probability of insolvency Decreases Increases

OPERATING LEVERAGE
Operating leverage is the firm’s ability to use the fixed operating cost to
magnify the effect of changes in sales on its earnings before interest and
taxes.

When the change in the operating profit after charging fixed cost is greater
than the percentage change in the sales, the occurrence is called the
operating leverage.

Operating leverage arises due to presence of operating costs which can be

categorised into three parts:

TYPES OF LEVERAGE IN FINANCIAL MANAGEMENT

Fixed costs: It refers to the costs which do not change with the change in the
production.

Variable costs: It refers to the cost which changes due to the change in the
level of the production. The amount of expenditure increases with the increase
in the level of the output and it decreases with the decrease in the level of
output.

Semi-variable costs: These are the costs that are partly fixed and partly
variable. These costs remain fixed up to a certain level and then starts
increasing with the change in the level of the output.

Operating leverage is associated with the business risk.

TYPES OF LEVERAGE IN FINANCIAL MANAGEMENT
Business or operating risk is the degree of the uncertainty that the firm has
faced in meeting its fixed operating cost where there is variability of EBIT.

CALCULATION OF OPERATING
LEVERAGE

TYPES OF LEVERAGE IN FINANCIAL MANAGEMENT

Example: Let Selling price per unit = ₹30

Production and sales= 600 units.

Variable cost= ₹18 per unit

Fixed cost= ₹1,200

The operating leverage will be calculated as follows:

Total sales (600@30) 18,000

Less: Variable cost (600*18) (10,800)

Contribution 7,200

Less: fixed cost (1,200)

Operating Profit or EBIT 6,000

OPERATING LEVERAGE= Contribution/ Operating profit = 7,200/6,000=
1.2

DEGREE OF OPERATING LEVERAGE:

The degree of operating leverage may be defined as the percentage change
in profits resulting from percentage change in sales.

DOL= Percentage change in EBIT/ Percentage Change in Sales

The degree of operating leverage must be greater than 1.

Ideal DOL= (Percentage change in EBIT/Percentage change in sales)>1

Example: A firm at present has a sales of 500 units @ ₹10 per unit. Its
variable cost is ₹7 per unit and fixed expenses are ₹800 per annum. The
firm’s expected sales for next year will be 700 units. Compute degree of
operating leverage.

Present sales (500 units) Expected sales (700 units)

Sales @ 10 per unit 5,000 7,000

Less: Variable cost @ 7 per unit (3,500) (4,900)

Contribution 1,500 2,100

Less: fixed costs (800) (800)

Operating Profit 700 1,300

Percentage Increase in EBIT= (Increase in EBIT/ Original EBIT)*100

=(600/700)*100

=85.71%

**** Increase in EBIT= 1300-700= 600

Percentage Increase in Sales= (Increase in sales/ Original sales)*100

=(2,000/5,000)*100

=40%
****Increase in sales= 7,000-5,000= 2,000

Degree of operating leverage= (Percentage change in EBIT/ Percentage

change in Sales)

= 85.71/40

=2.14

IMPORTANCE OF OPERATING
LEVERAGE
 It gives an idea about the impact of changes in sales on the operating
income of the firm.
 High degree of operating leverage indicates increase in operating profit
or EBIT.
 Higher operating leverage indicates increased number of sales required
to reach break-even point.
 Proper analysis of operating leverage of a firm is useful to the finance
manager.
 Higher fixed operating cost promotes higher operating leverage and
operating risk.

COMBINED LEVERAGE
Operating leverage shows the operating risk and is measured by the
percentage change in EBIT due to percentage change in sales.

The financial leverage shows the financial risk and is measured by the
percentage change in EPS due to percentage change in EBIT. Both operating
and financial leverages are closely concerned with ascertaining the firm’s
ability to cover fixed costs and the combination of both is known as combined
or total leverage.

The risk is associated with total leverage is known as total risk.

Combined Leverage= Operating Leverage* Financial Leverage

Combined Leverage= (C/ EBIT)*(EBIT/EBT)

Combined Leverage= C/ EBT or (Sales/Variable cost)/ (Sales- Variable

cost- Fixed cost)
DEGREE OF COMBINED LEVERAGE
The degree of combined leverage measures the effect of a percentage
change in sales on percentage change in EPS.

DCL= DOL*DFL

DCL= (Percentage change in EBIT/ Percentage change in sales)*

(Percentage in EPS/ Percentage change in EBIT)

DCL= Percentage changer in EPS/ Percentage change in sales

Combined leverage may be:

TYPES OF LEVERAGE IN FINANCIAL MANAGEMENT

IMPORTANCE OF COMBINED
LEVERAGES
 It indicates the effect that changes in sales will have on EPS.
 It shows the combined effect of operating leverage and financial
leverage.
 A combination of high operating leverage and high financial leverage is
very risky situation.
 A combination of high OL and low FL indicates the situation of high risk.
 A combination of low OL and high FL indicates the situation of
maximising return.
 A combination of low OL and low FL indicates that the firm losses
profitable opportunities.

SIGNIFICANCE OF LEVERAGES
MEASUREMENT OF OPERATING RISK: Operating risk refers to the risk of
the firm not being able to cover its fixed operating costs. Since, operating
leverage depends on operating costs, larger fixed operating costs indicates
higher degree of operating leverage and thus, higher operating risk of the firm.
High operating leverage is good when sales are rising but bad when they are
falling.

MEASUREMENT OF FINANCIAL RISK: It refers to the risk of the firm not

being able to cover its fixed financial costs. Since financial leverage depends
on fixed financial costs indicates higher degree of financial leverage and thus
high financial risk. High financial leverage is good when operating profit is
rising and when it is falling.

MANAGING RISK: Relationship between operating leverage and financial

leverage is multiplicative rather than additive. Operating leverage and
Financial leverage can be combined in a number of different ways to obtain a
desirable degree of total leverage and level of total firm risk.

DESIGINING APPROPROATE CAPITAL STRUCTURE MIX: To design an

appropriate capital structure mix or financial plan, the amount of EBIT under
various financial plans, should be related to earnings per share. One widely
used mean of examining the effect of leverage to analyse the relationship
between EBIT and earnings per share.

INCREASE PROFITABILITY: Leverage is an effort or attempt by which a firm

tries to show high result or more benefit by using fixed costs assets and fixed
return sources of capital. It ensures maximum utilization of capital and fixed
assets in order to increase the profitability of a firm. It helps to know the
reasons not having more profits by a company.

DIFFERENCE BETWEEN OPERATING

LEVERAGE AND FINANCIAL
LEVERAGE
Basis of
Operating leverage Financial leverage
difference

Use of the such assets in the

Use of debt in capital structure of
company’s operations for which it
Meaning company for which it has to pay interest
has to pay fixed costs is known as
expenses is known as financial leverage.
operating leverage.

It measures the effect of operating It measures the effect of interest

Measures
costs. expenses.

Relates It relates the sales and EBIT. It relates to the EBIT and EPS.

Preferable The operating leverage should be low The financial leverage should be high as
 it shows that the firm will incur profit
as it ensures that there is low level of
only when the operating profit or
operating risk.
contribution is rising.

Formula Contribution/ EBIT EBIT/EPS

Risk It gives rise to business risk. It gives rise to financial risk.

Percentage change in EBIT/

Degree EBIT/ EBIT-I Or EBIT/ EBT
Percentage change in sales

Cost/ Capital It is determined by the cost structure It is determined by capital structure of

structure of the firm. the firm.

Concerned It is concerned with investing It is concerned with financing activities

with activities of firm. of the firm.

It calculates the operating risk It calculates the financial risk associated

Calculates associated with mix of variable and with choice of sources of funds for
fixed operating expenses. financing the business.

It may be favourable or unfavourable It may be positive or negative to the

Nature
to the organisation. earnings of the organisation.

Impact when High DOL shows the higher degree High DFL shows the higher degree of
higher of business risk to the firm. financial risk to the firm.

High DFL is the situation in which the

Low DOL is situation which the
Impact when firm earns more from the assets
firm’s sales revenues are more when
ideal purchased with the funds than the cost of
compared to the operating costs.
funds.
TYPES OF LEVERAGE IN FINANCIAL MANAGEMENT
CONNECT ON LINKEDIN

TYPES OF LEVERAGE IN FINANCIAL MANAGEMENT