6.

MEANING AND TYPES OF LEVERAGE

2.1 Meaning of Leverage
The term leverage represents influence or power. In financial analysis, leverage
represents the influence of one financial variable over some other related
financial variable. These financial variables may be costs, output, sales revenue,
Earnings Before Interest and Tax (EBIT), Earning Per Share (EPS) etc.
Generally, if we want to calculate the impact of change in variable X on variable Y,
it is termed as Leverage of Y with X, and it is calculated as follows:

Change in Y÷Y
Measurement of Leverage=
Change in X ÷X

2.2 Types of Leverage

There are three commonly used measures of leverage in financial analysis. These are:
(i) Operating Leverage: It is the relationship between Sales and EBIT and
indicates business risk.

Operating Leverage Business risk

(ii) Financial Leverage: It is the relationship between EBIT and EPS and indicates
financial risk.

Financial Leverage Financial risk

(iii) Combined Leverage: It is the relationship between Sales and EPS and
indicates total risk i.e., both business risk and financial risk.
 6.2

Combined Leverage Total risk

2.3 Chart Showing Degree of Operating Leverage,

Financial Leverage and Combined leverage
Profitability Statement

Sales xxx

Less: Variable Cost (xxx)

Contribution xxx Degree of Operating

Less: Fixed Cost (xxx) Leverage

Operating Profit/ EBIT xxx

Less: Interest (xxx)

Earnings Before Tax (EBT) xxx Degree of

Less: Tax (xxx) Combined

Profit After Tax (PAT) xxx Degree of Financial Leverage

Less: Pref. Dividend (if any) (xxx) Leverage

Net Earnings available to xxx

equity shareholders/ PAT

No. Equity shares (N) xxx

Earnings per Share (EPS) xxx

(PAT ÷ N)

OPERATING LEVERAGE
 6.3

Operating Leverage (OL) means tendency of operating income (EBIT) to change

disproportionately with change in sale volume. This disproportionate change is
caused by operating fixed cost, which does not change with change in sales
volume.

In other words, Operating Leverage maybe defined as the employment of an

asset with a fixed cost so that enough revenue can be generated to cover all the
fixed and variable costs.

The use of assets for which a company pays a fixed cost is called operating
leverage.

Operating leverage is a function of three factors:

(i) Amount of fixed cost,

(ii) Variable contribution margin, and

(iii) Volume of sales.

3.1 Degree of Operating Leverage (DOL)

When we measure magnitude of disproportionate change, it is termed as degree of
leverage. Degree of Operating Leverage (DOL) may be defined as percentage
change in EBIT with respect to percentage change in sales quantity.

Percentage Change in EBIT

Degree of Operating Leverage (DOL) =
Percentage Change in Sales

Mathematically:

∆EBIT ∆Q
DOL = ⁄
EBIT Q
 6.4

Here,

EBIT = Q (S – V) – F

Q = Sales quantity

S = Selling price per unit

V = Variable cost per unit

 Denotes change

 [Q (S-V)-F] / [Q (S-V)-F]
DOL =
Q / Q

Now F is nil because change in fixed cost is nil. Therefore:

 Q (S-V)  Q  Q (S-V) Q Q (S-V)

DOL = ⁄ = × =
Q (S-V)-F Q Q (S-V)-F  Q Q (S-V)-F

Contribution Contribution
DOL = =
Contribution - Fixed Cost EBIT

3.2 Break-Even Analysis and Operating Leverage

Break-even analysis is a generally used to study the Cost Volume Profit analysis. It
is concerned with computing the break-even point. At break-even point (BEP) of
production level and sales, there will be no profit and loss i.e. total cost is equal
to total sales revenue.

Fixed Cost
Break-even point in units =
Contribution per unit
 6.5

Let us understand through the following example:

Example - 1:

Particulars Product X Product Y

(`) (`)

Selling Price p.u. 40 20

Variable Cost p.u. 20 12

Contribution p.u. 20 8

Total Contribution of 1,000 units 20,000 8,000

Fixed Cost 15,000 5,000

Profit (EBIT) 5,000 3,000

15,000 5,000
Break- even point (Fixed Cost / = 750 units = 625 units
Contribution 20 8

Operating Leverage 20,000 8,000

=4 = 2.67
 Contribution  5,000 3,000
 
EBIT 
 

There is a relationship between leverage and Break-even point. Both are used for
profit planning.
In brief, the relationship between leverage, break-even point and fixed cost is as
under:

Leverage Break-even point

1. Firm with high leverage 1. Higher Break-even point

2. Firm with low leverage 2 .Lower Break-even point

Fixed cost Operating Leverage

1. High fixed cost 1. High degree of operating leverage

2. Lower fixed cost 2. Lower degree of operating leverage

 6.6

FINANCIAL LEVERAGE
Financial leverage (FL) maybe defined as ‘the use of funds with a fixed cost in
order to increase earnings per share’. In other words, it is the use of company
funds on which it pays a limited return. Financial leverage involves the use of
funds obtained at a fixed cost in the hope of increasing the return to common
stockholders.
Earnings before interest and tax(EBIT)
Financial Leverage (FL) =
Earnings before tax(EBT)

Where, EBIT = Sales - (Variable cost + Fixed cost)

EBT = EBIT - Interest

4.1 Degree of Financial Leverage (DFL)

Degree of financial leverage is the ratio of the percentage increase in Earnings Per
Share (EPS) to the percentage increase in Earnings Before Interest and Taxes
(EBIT). Financial Leverage (FL) is also defined as “the ability of a firm to use
fixed financial charges to magnify the effect of changes in EBIT on EPS

Degree of Financial Leverage (DFL)

Percentage change in earnings per share (EPS)
=
Percentage change in earnigs before interest and tax (EBIT)
∆EPS ∆EBIT
DFL =
⁄
EPS EBIT
ΔEPS means change in EPS and ΔEBIT means change in EBIT.
 6.7

Now, EPS = [(EBIT - I)(1- t)] - D/No. of Shares

Here,
T = Tax Rate

D = Dividend on Preference Shares (inclusive of dividend tax if any)

On simplifying the above we get,
EBIT(1-t)
DFL =
(EBIT-Int.)(1-t) - DP
EBIT
DFL=
DP
(EBIT-Int.)- 1-t
If the company has not issued preference shares, then:
EBIT EBIT
DFL = =
EBIT-Int. PBT
When DFL is more than one (1), financial leverage exists. More is DFL, higher is
financial leverage.

A positive DFL/ FL means firm is operating at a level higher than break-even point
and EBIT and EPS moves in the same direction. Negative DFL/ FL indicates the
firm is operating at lower than break-even point and EPS is negative.

Let us understand through the following analysis:

Situation 1: No Fixed Interest charges

Particulars X Y
(`) (`)
EBIT 1,00,000 1,50,000
Tax @ 50% 50,000 75,000
PAT 50,000 75,000
No. of shares 10,000 10,000
EPS 5 7.5
Change in EP 50%
Degree of Finance Leverage (DFL) = = =1
Change in EBIT 50%
 6.8

Situation 2: Positive Financial Leverage

Particulars X Y
(`) (`)
EBIT 1,00,000 1,50,000
Interest 20,000 20,000
EBT 80,000 1,30,000
Tax @ 50% 40,000 65,000
PAT 40,000 65,000
No of Shares 10,000 10,000
EPS 4 6.5
*
Change in EPS 62.5%
Degree of Finance Leverage (DFL)= = =1.25
Change in EBIT 50%
 2.5 ×100 
 4 
*Change in EPS =
 
= 62.5%
50%
Situation 3. When EBT is nil (EBIT = Fixed Interest)
EBIT
Degree of Finance Leverage (DFL) = = Undefined
Nil

Financial Leverage

Positive Infinite/ Negative

Undefined

EBIT level is EBIT level is less

more than Fixed Operating at than Fixed
Financial Charge Financial break
Financial Charge
even point

EPS: will change in

the same direction No Profit no EPS : Negative
as EBIT Loss

Positive and Negative Financial Leverage

 6.9

Analysis and Interpretation of Financial leverage

Sl. No. Situation Result

1 No Fixed Financial Cost No Financial leverage

2. Higher Fixed Financial cost Higher Financial Leverage

3. When EBIT is higher than Financial Break-even Positive Financial leverage

point

4. When EBIT is less then Finance Break-even Negative Financial leverage

point

5. COMBINED LEVERAGE
Combined leverage may be defined as the potential use of fixed costs, both
operating and financial, which magnifies the effect of sales volume change on
the earning per share of the firm.
Combined Leverage (CL) = Operating Leverage (OL) × Financial Leverage (FL)
C EBIT
= ×
EBIT EBT
C
=
EBT
 6.10

5.1 Degree of Combined Leverage (DCL)

Degree of combined leverage (DCL) is the ratio of percentage change in earning
per share to the percentage change in sales. It indicates the effect the changes
in sales will have on EPS.

DCL = DOL × DFL

%Changein EBIT %Change in EPS
= ×
%Changein Sales %Change in EBIT
%Changein EPS
=
%Changein Sales

Like operating leverage and financial leverage, combined leverage can also be
positive and negative combined leverage.

5.2 Analysis of Combined Leverage

Combine leverage measures total risk. It depends on combination of operating
and financial risk.

DOL DFL Comments

Low Low Lower total risk.

Cannot take advantage of trading on equity.

High High Higher total risk. Very risky combination.

High Low Moderate total risk. Not a good combination.

Lower EBIT due to higher DOL and lower advantage of trading on
equity due to low DFL.

Low High Moderate total risk. Best combination.

Higher financial risk is balanced by lower total business risk.
 6.11

ILLUSTRATION
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).
Consider tax @ 50 %.

CALCULATE:
(a) Operating Leverage
(b) Financial Leverage

(c) Combined Leverage

(d) Return on Investment
(e) If the sales increases by ` 6,00,000; what will the new EBIT?
SOLUTION

(`)
Sales 24,00,000
Less: Variable cost 12,00,000
Contribution 12,00,000
Less: Fixed cost 10,00,000
EBIT 2,00,000
Less: Interest 1,00,000
EBT 1,00,000
Less: Tax (50%) 50,000
EAT 50,000
No. of equity shares 10,000

EPS 5
 6.12

`12,00,000
(a) Operating Leverage   6 times
`2,00,000
`2,00,000
(b) Financial Leverage   2 times
`1,00,000

(c) Combined Leverage = OL × FL = 6 × 2 = 12 times.

`50,000
(d) ROI   100  5%
`10,00,000
EAT-Pref.Dividend
Here ROI is calculated as ROE i.e.
Equity shareholders'fund

(e) Operating Leverage = 6

Δ EBIT
6=
0.25
6 1
Δ EBIT   1.5
4
Increase in EBIT = ` 2,00,000 × 1.5

= ` 3,00,000

New EBIT = ` 5,00,000