LEVERAGE ANALYSIS fundamentals of financial management operating leverage combined leverage,financial leverage

1. Dr. Hari Singh Gour Central
University sagar (M.P.)
2017-18
Department Of Business Management
“Leverage Analysis”
Prepared by- Submitted To:-
Nischal Choudhary Miss. Preeti Dhanak
Y16180501
BBA-3rd Sem

2. Meaning and Definition 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
asset or funds to increase the return to its owners; i.e. equity share holders. 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.
 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. Significance of Leverage
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.
 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.

4. 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

5. In Finance, leverage refers to the use of fixed costs to magnify the potential
return to a firm
Types of fixed costs:
Fixed Operating costs e.g.- rent, depreciation
Fixed Financial costs e.g.- interest costs on long term debt (Debentures) ;
Preference Dividend
Total Fixed Cost – Sum total of the above two
Classification of Leverage
Just as fixed costs may be broadly classified into:
• Operating Fixed Cost; and
• Financial Fixed Cost,
• Total Fixed Cost
Likewise, leverage may be classified into:
• Operating Leverage
• Financial Leverage
• Combined Leverage / Total Leverage

6. Operating Leverage
The “Operating Leverage” measures the relationship between the sales
revenue and the EBIT.
Leverage associated with asset acquisition/investment activities is referred to
as the operating leverage. It may be defined as the ability to use fixed operating
costs to magnify the effect of changes in sales on its operating profits (EBIT).
Thus, operating leverage is determined by the relationship between sales
revenue and EBIT.
When proportionate change in EBIT as a result of change in sales is more
than the proportionate change in sales, operating leverage occurs.

7. Conclusion;
Analysis of operating leverage of a firm is very useful to the
financial manager.
It tells the impact of change in sales on the level of operating
profits of the firm.
A firm with high DOL can experience a magnified effect on
EBIT for even a small change in sales Level.
Operating leverage exists only when there are fixed operating
costs.
•If there are no fixed operating costs, there will be no operating
leverage.

8. Financial Leverage
•The Financial Leverage measures the relationship between the EBIT
and the EPS.
•It reflects the effect of a change in EBIT on the level of EPS.
• It results from the presence of fixed financial charges (such as interest
on debt and dividend on preference shares).
•Financial leverage is related to the financing activities of a firm.
•Since such financial expenses do not vary with the operating profits,
financial leverage is concerned with the effect of changes in EBIT on the
earnings available to equity-holders.
•It is defined as the ability of a firm to use fixed financial charges to
magnify the effect of changes in EBIT on the earnings per share (EPS).

9. •Financial leverage exists only when there are fixed Financial
costs (e.g. Interest on Debentures, Preference Dividend) .
•If there are no fixed Financial costs, there will be no Financial
leverage.

10. COMBINED LEVERAGE
• Combined leverage is the product of operating and
financial leverage.
• It indicates the effect that sales changes will have on EPS.
•Degree of combined leverage (DCL) = DOL´DFL
Percentage change in EBIT Percentage change in EPS
Percentage changes in sales Percentage change in EBIT ´
Alternatively
=Sales -Variable costs X EBIT
EBIT EBIT- I
= Sales - Variable costs
EBIT- I

11. Illustration : The installed capacity of a factory is 800
units. Actual capacity uses is 400 units. Selling price
per unit is Rs.10. Variable cost is Rs.6 per unit. Calculate the
operating leverage in each of the following three situations
•.When fixed costs are Rs.400
•.When fixed costs are Rs.1,000
•When fixed costs are Rs.1,200
Particulars Situation Situation Situation
1 2 3
(i) Sales Rs. 4,000 Rs. 4,000 Rs. 4,000
(ii) Variable Cost 2,400 2,400 2,400
(iii) Contribution (i -ii) 1,600 1,600 1,600
(iv) Fixed Cost 400 1,000 1,200
(v) Operating Profit (iii - iv) 1,200 600 400
(vi) Operating Leverage (1,600/1,200) (1,600/600) (1,600/400)
(C/OP) 1.33 2.67 4

12. THANK YOU