2. Meaning of leverage
In general ,leverage refers to accomplish certain things which are otherwise not
possible i.e. lifting of heavy objects with the help of lever. This concept of leverage
is valid in business also .
In finance ,the term ‘leverage’ is used to describe the firm’s ability to use fixed cost
assets or funds to increase the return to its owners; i.e. equity shareholders. In
other words, the fixed cost funds i.e. debentures & preference share capital act as
the fulcrum , which assist the lever i.e. the firm to lift i.e. to increase the earnings
of its owner i.e. the equity shareholders.
If earnings less the variable costs exceed the fixed costs i.e. preference dividend &
interest on debenture, or earnings before interest and taxes exceed the fixed
return requirement, the leverage is called favorable . when they do not ,the result
is unfavorable leverage .
Leverage is also the influence which an independent variable has over a
dependent/related variable i.e. rainfall over production. In financial context, sales
& fixed cost over profit.
3. DIAGRAM
Leverage in physics Leverage in finance
LEVER LIFTING
Increasing
the
earnings
Fixed
cost
fund
FULCRUM
4. TYPES OF LEVERAGE
OPERATING LEVERAGE
The leverage associated with investment (asset acquisition)
activities is referred as operating Leverage.
Formula : operating leverage=contribution/operating profit
Where , contribution=sales-variable cost
operating profit=sales-variable cost-fixed cost
Operating leverage is also defined as the ratio of the percentage
change in operating income for a given percentage change in sales.
DOL=%change in operating income/%change in sales
The risk associated with operating leverage is called operating risk . It is
the risk of not being able to cover fixed operating costs by firm
5. ILLUSTRATION
• Following is the cost information of a firm:
• Fixed cost=Rs.50000
• Variable cost=70%of sales
• Sales=Rs.250000
• Now , Operating Leverage=contribution/operating profit
=75000/25000
=3
6. BREAK EVEN ANALYSIS
A break-even analysis shows the relationship between the
costs and profits with sales volume.
The sales volume which equates total revenue with related
costs and results in neither profit nor loss is called the break –
even volume or point.
At break – even point the fixed costs are fully recovered , any
increase in sales beyond this level will increase profit.
7. OPERATING BREAK EVEN
The operating break even point is defined as that level of sales (either units or money
value)at which EBIT (operating profit) is equal to zero:
Sales-VC-FC =0
or
Q(P-V)-FC =0
Where ,VC is total variable cost , FC is total fixed cost ,Q is the quantity , P is the selling
price per unit & V is the variable cost per unit
A firm operating with a high degree of leverage and above break even point earn good
amount of profit.
DOL is undefined at the operating break –even point
IF Q is less than the operating break even point ,then DOL will be negative & vice versa
8. OPERATING BREAK EVEN
Operating break even point in units
Formula:break even point=fixed cost/selling price per unit-
variable cost per unit
Operating break even point in terms of money value
Formula :break even sales=(fixed cost/sales-variable cost)*sales
=(fixed cost/contribution)*sales
=fixed cost/P/V ratio
(As, contribution/sales=P/V ratio)
9. OPERATING BREAK EVEN :AN
EXAMPLE
Consider the following information pertaining to Visakha Metals:
Quantity produced 1000 units
Variable cost per unit Rs.475000
Selling price per unit Rs.600000
Fixed cost Rs.5 crore
Now , operating BEP in units =Fixed cost/selling price per unit-variable cost per unit
=50000000/600000-475000
=50000000/125000
=400 units
or
BEP in terms of money value=(Fixed cost/contribution per unit)* sp per unit
=400*600000
=Rs.240000000
10. FINANCIAL LEVERAGE OR
TRADING ON EQUITY
Leverage associated with financing activities is called financial leverage
The use of long term fixed interest bearing debt and preference share capital
along with equity share capital is called financial leverage or trading on equity
It measures the effect of the change in EBIT(operating profit)on the
EPS(earning per share)of the company
The measure of financial leverage is the degree of financial leverage
Formula : DFL= %change in EPS /% change in EBIT
or
DFL=EBIT/(EBIT-Interest)-preference dividend/1-tax rate
The risk associated with financial leverage is called financial risk . Financial
risk is the risk of not being able to cover fixed financial costs by the firm
11. FINANCIAL LEVERAGE:AN EXAMPLE
• Given : Total sales=Rs.1400000
Contribution ratio=25%
Fixed expenses=Rs.150000
O/S bank loan=Rs.400000@12.50%
Preference S/C=Rs.200000@15%
Tax rate=40%
DTL=200000/(200000-50000)-30000/.60
=2
12. FINANCIAL BREAK EVEN
Financial BEP is the level of EBIT(operating income) which is equal to firm’s fixed
financial cost
Financial break even point=(Interest + preference dividend)/1-
tax rate
Financial BEP is the level at which EPS(net income) is equal to zero
EPS=EBIT-interest-preference dividend=0
DFL is undefined at the financial Break –even point
DFL will be negative when the EBIT level goes below the financial Break –
even point & vice versa
13. FINANCIAL BREAK EVEN :AN EXAMPLE
• X ltd achieves a sales of Rs. 20 lakh for the year ended2003-04 The
variable cost ratio is 70% and fixed cost is Rs.5 lakh .The company’s capital
structure consists of 25000 equity shares, 2000 15%preference shares of
face value Rs.100. If the corporate tax rate is 40%,the financial break even
point for X ltd is
Financial BEP=(I+ preference dividend)/1-tax rate
=(0+300)/.60
=50000
14. COMBINED LEVERAGE
Combined leverage is the product of operating leverage and
financial leverage
The measure of total leverage is the degree of total leverage
Formula : DTL=DOL*DFL
=%change in EBIT/%change in sales*%change in
EPS/%change in EBIT
or
DTL=contribution/EBIT*EBIT/EBIT-interest=contribution/EBIT-
interest
Total risk is the risk associated with combined
leverage
15. COMBINED LEVERAGE: AN EXAMPLE
The Supreme & C o Ltd given the following information:
Equity earnings 230000
Quantity produced 7500 units
Variable cost per unit Rs.300
Selling price per unit Rs.600
No of equity shareholders 700000
Fixed expenses Rs.1000000
Interest Rs. 95000
Preference dividend Rs.35000
Corporate tax 40%
DCL=Contribution/(EBIT-Interest)-preference dividend/1-tax rate
=2250000/(1150000)-35000/.60
=2.05
16. COMBINED BEP
The overall break-even is that level of output at which the DTL will be
undefined and EPS is equal to zero
Formula :Quantity=(Fixed cost +Interest +preference dividend/1-tax rate)/(s-v)
If the level of output is less than the overall break-even point ,then
the DTL will be negative
If the level of output is greater than the overall break –even point ,
then the DTL will be positive.DTL decreases as Q increases and
reaches a limit of 1.
17. COMBINED BEP :AN EXAMPLE
If the fixed cost is Rs.30000,the operating BEP in units is 3000and financial
BEP is Rs.5000,the overall BEP in units
Solution:overall BEP=(f +I +preference dividend/1-tax rate)/s-v
Financial BEP=I +preference dividend/1-tax rate=Rs.5000
Operating BEP=f/s-v=3000 units
Thus , s-v=30000/3000=10
Overall BEP=(5000+30000)/10=3500
