LEVERAGE

Concept of Leverage Leverage indicates the tool which can lift heavy weight by using a little force. Leverage in financial terms means any financial technique which can serve this purpose. It shows the magnification of force. That is why it is also termed as Gearing. Leverage is the employment of an asset or fund for which the firm pays a fixed cost or fixed return.

Significance The term leverage refers to a relationship between two interrelated variables. In financial analysis, the leverage reflects the responsiveness or influence of one financial variable over some other financial variable. It quantifies the relative changes in profit due to change in the sales. It depicts the change in fixed costs incurred to sell the goods.

Contd. It helps the management in controlling operating costs or varying the profit with an element of risk. It also helps in forecasting. It helps in understanding the relationship between any two variables. However, the two variables for which the relationship is to be established should be interrelated, otherwise, the leverage study may not have any useful purpose to serve.

Contd. The two variables when varied show the relative changes. This variation is called “Degree of Leverage.” % Change in dependent variable Degree of Leverage = % Change in independent variable

Master Table to Calculate the Leverage Sales Less: Variable Cost Contribution Less: Fixed Cost Operating Profit or EBIT Less: Interest Earning before Tax (EBT) Less: Tax Earning after Tax Less: Preference Dividend Earning Available to Equity Shareholder

Contd. Leverages - Interest Profit Before Tax - Tax Profit After Tax Sales Revenues Leverages EBIT - Variable Cost - Interest Contribution Profit Before Tax -Fixed Cost - Tax Profit After Tax

Types of Leverages: Operating Leverage Financial Leverage Combined Leverage

Contd. The relationship between sales revenue & EBIT is defined as Operating Leverage & relationship between EBIT & EPS is defined as Financial Leverage.

Contd. The increase in the EBIT indicates fast recovery of fixed cost from sales revenues. Lesser the fixed cost, more will be the EBIT and operating leverage.

Contd. Increase in the Earning per Share (EPS) refers value addition in the shareholder’s wealth & vice- versa. So, more the financial leverage more will be EPS.

Operating Leverage The operating leverage shows the relationship between EBIT & Sales revenues. Contribution Operating Leverage = EBIT

Contd. The degree of operating leverage (DOL) can be expressed as follows. % Change in EBIT DOL = % Change in Sales Revenue

Financial Leverage The use of fixed charge sources of funds along with owner’s equity is described as financial leverage. It focuses on earn more return on fixed charges funds (debt) than their costs. High rate of financial leverage shows fast growth in EPS in the growing profit era. But in the declining profit phase it also shows fast decrease in the EPS.

Contd. So, in short, we can say the leverage shows the pace of profit or loss. It also shows relationship of fixed (Interest) & variable (Dividend) compensation paid or payable on debt & equity fund respectively.

Contd. EBIT Financial Leverage = ` EBT EBT = EBIT – I I= Interest

Contd. The degree of Financial Leverage can be expressed as follows. % Change in EPS DFL = % Change in EBIT

Combined Leverage: Combined leverage is combination of both the leverages. Combined Leverage = Operating Leverage X Financial Leverage or EBIT Contribution Combined Leverage = X EBT EBIT Contribution Combined Leverage = EBT

Difference between Operating & Financial Leverage Operating Leverage Financial Leverage Operating Leverage is related to the investment activities (capital expenditure decision) Financial leverage is more concerned with financial matters. (Capital structure or Debt & equity mix) The Fluctuation in the EBIT can be predicted with the help of operating leverage. The change of EPS due to Debt equity mix is predicted by financial leverage. Financial Manager Uses the operating leverage to identify the items of assets side of Balance Sheet. The use of financial leverage is to make decision in the liability side of the Balance sheet. Operating leverage is used to predict Business risk. Financial leverage is used to analyses the financial risk.