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Leverage Analysis
(Measurement of Risk)
Types of Cost to understand Leverage:-
1. Fixed Cost: - It is the cost which remains fixed at every
level of output. It is to be incurred in every
circumstance whether there is any production or not.
For Example: - Rent, Salary etc.
2. Variable Cost: - It is the cost which increases with the
increase in the output or decreases with the decrease
in the output. If no output has been produced, then there
will be no variable cost.
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Conclusion: - Risk / Leverage will always arise due to
Fixed Cost as if there is an output Fixed cost may or may not
be recovered as we have seen above but Variable Cost will
always be recoverable because selling price will always be
more then variable cost.
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Calculation of Operating Leverage
Let’s understand the same with an Example:-
Income Statement Case A Case B Case C
Sales 20,000 20,000 20,000
(-) Variable Cost 13,000 13,000 13,000
Contribution 7,000 7,000 7,000
(-) Operating Fixed Cost 2000 1000 NIL
Earnings Before Interest & Tax
(EBIT) 5,000 6,000 7,000
Operating Leverage can be calculated
by the relationship of Contribution &
EBIT, i.e. =1.40 =1.167 =1
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From the above table, following important points can be
concluded: -
1. Higher the Fixed Operating Cost, Higher the Leverage & Vice
Versa.
2. If the Fixed Cost of Production is Zero Leverage will not be
Zero but equal to 1.
3. The minimum value of the Operating Leverage will always be
1, or we can say that Operating Leverage will never be less
than 1 because for any fraction to get less than 1 Numerator
should be less than Denominator & it is not possible for
contribution (Numerator) to be less than EBIT (Denominator) .
4. If the Operating Leverage of the company is high then the
company should try to lower its Financial Leverage (Financial
Risk) as both the risk should not be taken at the same time.
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Analysis of Operating Leverage: -
Leverage measures the degree of % change in one component due to
1 % change in another component.
Or we can also say that,
Leverage can be defined as the % change in Denominator due to 1
% change in Numerator. (It is applicable to all types of Leverage)
Therefore, Operating Leverage which is (contribution/EBIT) can be
defined as the % change (increase or decrease) in EBIT due to 1 %
change in Contribution or Sales.
If we apply the above concept in the CASE A given on the Table
then it means that if Sales increase or decrease by 1 % then the
EBIT will increase or decrease by 1.40%.
Let us understand the situation by an example.
In Case A if sales increase by 50 % then the EBIT will increase by:-
50 X 1.40 = 70 %.
As the change in EBIT due to 1 % change in Sales is 1.40 &
therefore due to change in 50 % it must be more than 50 % and that
is 70 % as calculated above.
Now we will check whether it holds good or not.
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Income Statement Case A Case A’
Sales 20,000 30000
(-) Variable Cost 13,000 19500
Contribution 7,000 10500
(-) Operating Fixed Cost 2000 2000
Earnings Before Interest & Tax (EBIT) 5,000 8500
x100 or x 100
For % Change =
= x100 = 70%
So that 70 % was earlier calculated as:-
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Financial Leverage: - Financial Leverage may be defined as the
ability of the firm to use fixed cost of capital to magnify the effect
of changes in EBIT. Financial leverage results from the presence of
fixed financial charges (e.g. interest on debentures) in the firm’s
income stream. These fixed charges do not vary with the EBIT.
F.L can be calculated as follows: -
Earnings Before Interest & Tax XXX
Less:- Interest XXX
Earning Before Tax XXX
Financial Leverage can be calculated by the relationship of
EBIT & EBT, i.e.
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The effect of changes in Net Operating Profit or EBIT
on the level of Earning per share (EPS) is measured by
financial leverage. The financial leverage is also
calculated as:
⮚COMBINED LEVERAGE
Degree of Combined Leverage (DCL) is the product of
DOL & DFL. The operating leverage has its effects on
operating risk & is measured by the percentage change in
EBIT due to percentage change in sales. The financial
leverage has its effects on financial risk & is measured by
the percentage change in EPS due to percentage change in
EBIT. Since both these leverage are closely concerned
with ascertaining the ability to cover fixed charges (fixed-
operating costs in the cost of operating leverage & fixed-
financial costs in the case of financial leverage) , if they
are combined, the result is total leverage & the risk
associated with combined leverage is known as Total Risk.
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Degree of Combined Leverage (DCL) measures the
sensitivity of EPS to changes in sales. It is also calculated
as:
⮚ BUSINESS RISK AND FINANCIAL RISK
BUSINESS RISK FINANCIAL RISK
Business Risk or operating risk in the Financial Risk is created by the use of
risk associated with the normal day to fixed-cost securities (that is, debt &
day operations of the firm. preference shares).
An entity carrying on a business may, in An entity may, in order to finance its
order to carry its day to day operations, business, burden itself with same
burden itself with some operating fixed financial fixed costs which will be
costs which will be incurred irrespective incurred irrespective of the fact whether
of the fact whether the entity makes any the entity makes any profits or not.
sales or not.
Examples of such operating fixed costs Examples of such financial fixed costs
are: Rentals, Salaries, Electricity & are: interests on debt, preference
Telephone Expenses etc. dividends.
Business risk represents the variability in Financial risk is the variability in the
return created by a firm’s uses of funds. owner’s return created by a firm’s Fixed
Cost Capital
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It is unavoidable It is avoidable
It is not within the control of the It is controllable risk because it is
company because operating fixed cost associated with a capital structure
will continue to incur irrespective of the decision of the firm
level of revenues generated.
Operating risk can be measured Financial risk can be measured through
through
DFL = EBIT/EBT
DOL = Contribution/EBIT
Financial Leverage: - Financial Leverage may be defined as the ability of the firm
to use fixed cost of capital to magnify the effect of changes in EBIT. Financial
leverage results from the presence of fixed financial charges (e.g. interest on
debentures) in the firm’s income stream. These fixed charges do not vary with the
EBIT.
⮚ Comparative Analysis of Operating Leverage & Financial Leverage:
Operating Leverage Financial Leverage
It indicates the tendency of operating It indicates the tendency of PBT to
profits (i.e. EBIT) to vary vary disproportionately with operating
disproportionately with sales. profits (i.e. EBIT)
It is related to fixed operating cost It is related to financial fixed cost.
High DOL indicates high operating High DFL indicates high financial
fixed cost fixed cost
If contribution exceeds fixed cost, If ROI exceeds the rate of interest on
operating leverage will be favourable debt, financial leverage will be
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& vice versa. favourable & vice versa
It indicates Business Risk It indicates Financial Risk
⮚ COMBINED LEVERAGE
Degree of Combined Leverage (DCL) is the product of DOL & DFL. The
operating leverage has its effects on operating risk & is measured by the
percentage change in EBIT due to percentage change in sales. The financial
leverage has its effects on financial risk & is measured by the percentage
change in EPS due to percentage change in EBIT. Since both these leverage are
closely concerned with ascertaining the ability to cover fixed charges (fixed-
operating costs in the cost of operating leverage & fixed-financial costs in the
case of financial leverage) , if they are combined, the result is total leverage &
the risk associated with combined leverage is known as Total Risk.
[ ]
Degree of Combined Leverage (DCL) measures the sensitivity of EPS to
changes in sales. It is also calculated as:
Degree of Combined Leverage (DCL) measures the sensitivity of EPS to
changes in sales. It is also calculated as:
[ ]
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