Lever is an inducing or compelling force.
Leverage is the action of a lever or the mechanical advantage gained by it; it also
means `effectiveness' or `power'
Leverage is used to explain a firms ability to use fixed-cost assets or funds to magnify the
returns to its owners. Leverage exists whenever a company has fixed costs. There are three
types of leverage in financial management:
Operating,
Financial,
Total/Combined leverage.
OPERATING LEVERAGE
Operating leverage is based on the relationship between a firms sales revenue and its
earnings before interest and taxes (operating profit).
Operating leverage is the name given to the impact on operating income as a result of a
change in the level of output (sales). It is the use of fixed operating costs by the firm
regardless of the volume of sales.
High Operating leverage arises when an enterprise has a relatively large amount of
fixed costs in its total costs and a small amount of variable costs.
Low Operating leverage arises when an enterprise has a relatively small amount of
fixed costs in its total costs and a large amount of variable costs.
No operating leverage when no fixed operating costs.
Degree of operating leverage
Degree of Operating Leverage is the percentage change in net operating income in
response to a percentage change in sales (volume or value).
The degree of operating leverage is directly proportional to a firms level of business
risk and therefore it serves as a proxy for business risk.
DOL
=
% change in EBIT
% change in Sales
or
DOL = Contribution
EBIT
DOL is favourable if contribution exceeds the fixed costs. In reverse case operating leverage
will be unfavourable.
High DOL means a small change in sales will have large effect on operating income
(EBIT).High DOL is a very risky situation.
FINANCIAL LEVERAGE
Financial leverage is based on the relationship between a firms taxable income and its
earnings before interest and taxes (operating profit). Financial leverage is the name given to
the impact on taxable income as a result of a change in the operating income. Financial
leverage is a financial technique that uses borrowed funds or preferred stock (items involving
fixed financial costs) to improve the return on an equity investment. It is the use of fixed
financing costs (fixed interest/dividend bearing securities) along with owners equity in the
capital structure by the firm. The British expression is gearing.
High financial leverage arises when the amount of debt used to finance a firm's assets
is significantly more than equity.
Low financial leverage arises when the amount of debt used to finance a firm's assets
is significantly less than equity.
No financial leverage arises when no debt is used to finance a firm's assets.
Degree of financial leverage
Degree of Financial Leverage is the percentage change in net income available to
equity investors in relation to changes in earnings before interest and taxes.
The degree of financial leverage is directly proportional to a firms level of financial
risk and therefore it serves as a proxy for financial risk.
DFL = % change in EPS
% change in EBIT
=
EBIT
=
EBIT
EBIT Interest
PBT
DFL is favourable (positive) if earnings made by the use of fixed interest/dividend bearing
securities exceed the explicit fixed costs for employment of such funds. In reverse case
operating leverage will be unfavourable (negative).
High DFL means a high fixed costs and high financial risk. The capital structure of a firm
must be planned so as to meet the fixed financial costs. Failure to do so will force the Co. in
liquidation.
COMBINED LEVERAGE
In fact, degree of operating leverage (DOL) is viewed as the first-stage leverage and degree
of financial leverage (DFL) as the second-stage leverage.
A combination of operating and financial leverage measures the degree of magnification in
Earnings per Share (EPS) for a given increase in sales. When the use of operating and
financial leverage is considerable, small changes in sales will produce wide fluctuations in
NI, ROE and EPS.
Degree of Combined Leverage (DCL)
Degree of Combined Leverage is the percentage in EPS /net income after interest and taxes in
response to percentage variations in sales (volume or value).
DCL = DOL X DFL
DCL= % change in EPS
% change in Sales
= Contribution
PBT
DCL indicates the total risk of the firm. You may note that a number of combinations of DOL
and DFL may produce the same DCL. And if management has a target DCL, changes in DOL
or DFL may be made to attain the targeted DCL. For instance, if the firm has a high degree of
operating leverage clue to the nature of its operations, the degree of financial leverage may be
suitably lowered so as not to lower the targeted combined leverage and vice versa.
DOL
DFL
DCL
High
High
Risky
High
Low
Normal
Low
High
Normal
Low
Low
Ideal
