Assignment

on

Leverage AND IT’S TYPES

Under the subject of

FINANCIAL MANAGEMENT

Submitted to Submitted by

MR. ASIM SAHORE MUHAMMAD SALIM

(Faculty MBA, TIAS) 07217003909

MBA (2nd semester)
LEVERAGE
Leverage in business is derived from the word ‘lever’. A lever is a simple tool by which a
large weight can be moved with a small force. The study of Leverage starts with our
understanding of break-even or the point at which a firm covers both fixed and variable
costs.

Leverage is the relationship between debt financing and equity financing, also known as
the debt-to-equity ratio. A method of corporate funding in which a higher proportion of
funds is raised through borrowing than stock issue. The use of fixed costs in order to
increase the rate of return from an investment. One example of leverage is a company
using debt financing to pay for an expansion of its operations. Even greater leverage is
created when a company issues debt in order to raise funds that are used to repurchase
stock. While leverage can operate to increase rates of return, it also increases the
amount of risk inherent in an investment, for both individuals and businesses.

Equity is created by the personal funds of the business owner(s), and/or by the
stockholders of shares in a corporation. As these funds have no claim on any of the
assets of the business, the assets are available to be used as collateral for debt
financing.

You can think of leverage as shorthand for your business's ability to get funding. Higher
equity creates increased leverage and vice-versa. If your business is fully leveraged, it
won't be able to borrow money.

Leverage means to get more with little force as in physics. But in accounting it tells us
how we can know from our sales that how much EBIT (earnings before interest and
taxes) will be. In accounting it is called degree of leverage and is calculated as: -
DOL= contribution margin/EBIT
For exp., if DOL=2 It means if we increase sale by 5% EBIT will increase by (2*5%)
10%.

TYPES OF LEVERAGE

There are three types of leverages which are as follows:-

1) Financial leverage

2) Operating leverage

3) Combine leverage

All these leverage are explained as follows

  OPERATING LEVERAGE
Operating leverage is a measure of the extent to which, fixed operating costs are being
used in an organization.

It is greatest (largest) in companies that have a high proportion of fixed operating costs in
relation (proportion) to variable operating costs. This type of company is using more fixed
assets in the operation of the company.

Conversely, operating leverage is lowest in companies that have a low proportion of fixed
operating costs in relation to variable operating costs.

Firms with large amounts of fixed operating costs have high break-even points and high
operating leverage. Variable cost in these firms tends to be low and both the contribution
(CM) and unit contribution (UC) margin is high.

Formula(s) for calculating Operating leverage:

Percent Change in Operating Income
Degree of Operating Leverage = Percent Change in Sales

Or
Contributi on Margin
Degree of Operating Leverage = Earnings Before Interest and Taxes

Or
Total Sales − Total Variable Cost
Degree of Operating Leverage = Total Sales −Total Variable Cost −Total Operating Fixed Cost

Or

Degree of Operating Leverage =

 Q ua w at Ohn ipt ci eth yr a t i n g
L e i cvs oe mr ax p g ( uPe t r e ui d−cVn e i a ct roP iu sae) nt br i ltp e e r
 Q ua w at Ohn ipt ci eth yr a t i n g 
 L e i Cvs e o r max (Pgp peru u ei t− cVnre eida t c rp oui e a)sn− r Obt i tl peF e Ci r x ao e tsd i t ns g
 
Example:

Company A and Company B are competitors in the market for a special machine part. The
cost structure and price details are given below:

Company A Company B

Selling price AED 30 AED 30

Variable cost per unit AED 10 AED 20

Fixed costs AED 60,000 AED 20,000

Question: Which firm has a high degree of operating leverage?

Answer:

C-V-P analysis of Company A and Company B

Company A

Units sold Variable costsFixed costs Total costs Revenue Operating

Income
(loss)
 0

2,000

3,000

4,000

5,000

Company B

Units sold Variable costsFixed costs Total costs Revenue Operating

Income
(loss)

2,000

3,000

4,000

5,000

Calculations of “Degree of Operating Leverage”:

Implications:

1. A firm with a high break-even point is more risky than one with a low Break – even
point. In periods of increasing sales, operating income (OI or EBIT) of the leveraged firm
tends to increase rapidly. This increase in OI (EBIT) is the ‘pay-off’ for being more risky.
But in periods of decreasing sales, operating income of the firm tends to decrease rapidly,
that is the risk.

2. Firms with small amounts of fixed operating costs have low break-even points and
are therefore less risky and have low operating leverage. Variable costs in these firms
tend to be high and both the CM and UC are low. In periods of increasing sales,
Operating income (EBIT) for these firms tends to increase slowly. But in periods of
decreasing sales, Operating income will tend to decrease slowly making the firm less
risky.

3. In conclusion, if a company has high operating leverage, then the operating income
(OI or EBIT) will become very sensitive to changes in sales volume. Just a small
percentage (%) chance in sales can yield (produce) a large percentage change in
Operating Income. A Company with low operating leverage the reverse is true.

 FINANCIAL LEVERAGE
Financial leverage is the extent to which debt (liability) is used in the Capital Structure
(financing) of the firm. Capital Structure refers to the relationship between assets, debt
(liability) and equity. The more debt a firm has relative to equity the greater the financial
leverage (these firms have a higher Debt to Asset ratios).

Example:

Let us say both companies have the following capital structure:

Company A Company B

Debt (10%) 100,000 Debt (10%) 40,000

Sh. Equity (AED 10 par) 40,000 Sh. Equity (AED 10 par) 100,000

(4,000 shares) --------- (10,000 shares) ----------

Total Capital 140,000 Total Capital 140,000

Substantial use of debt will place a great burden on the firm at low levels of profitability
(low EBIT, since interest must be paid). However, it will also help to magnify (enlarge)
increases in earnings per share (EPS) as the EBIT or operating income increases.

Percent Change in Earnings Per Share

Degree of Financial Leverage = Percent Change in Operating Income

or

Earnings Before Interest and Taxes

Degree of Financial Leverage = Earnings Before Interest and Taxes − Interest

Calculations of Income statements at different levels of operations:

Company A AED Company B AED

Sales(4,000 units) Sales (4,000 units)

Less: Var. costs Less: Var. costs

Fix. costs Fix. costs

EBIT EBIT

Less : Interest Less : Interest

EBT EBT

Less: Tax (50%) Less: Tax (50%)

EAT EAT

EPS EPS

Sales Sales

(5,000 units) (5,000 units)

Less: Var. costs Less: Var. costs

Fixed costs Fixed costs

EBIT EBIT

Less : Interest Less : Interest

EBT EBT

Less: Tax (50%) Less: Tax (50%)

EAT EAT

EPS EPS

Implications:
1. Financial leverage can be very useful to a firm if properly used under the right
conditions. For firms in industries that have a degree of stability and/or show growth, the
use of debt is recommended because of the positive aspects of financial leverage.

BUT…

2. As a firm increases the use of debt in its capital structure, creditors (lenders) will
perceive a greater financial risk in lending money to the firm and therefore may charge a
higher interest rate which may lower earnings before tax (EBT). These lenders will
perhaps place other restrictions on the firm. Stockholders may become concerned with
the risk to EPS and sell the stock (which will force the market price down).

3. In conclusion, financial leverage is a very useful tool if used correctly and under the
right conditions. At times, the value of the firm is enhanced by financial leverage.

 COMBINED LEVERAGE
When financial leverage is combined with operating leverage the effect of a change in
output (sales) in magnified in the change in earning per share (EPS). Operating leverage
gives us the change in EBIT with a change in sales and financial leverage gives us the
change in EPS with a change in EBIT. We can then see the change in EPS for a change
in sales (volume of output). The combining both concepts as can be seen below:

Operating Leverage is:

 Change in sales leads to a change in EBIT

Financial Leverage is:

Change in EBIT leads to a change in EPS

Therefore, Combined Leverage is:

Change in sales leads to a change in EPS.

Now, we can determine the effect of a change in output (sales) on earnings per share
(EPS). In this way, we can better depict the relative influence of the two types of leverage
for the firm. We can determine and examine the effect of adding financial leverage on top
of operating leverage.

Percent Change in Earnings Per Share

Degree of Combined Leverage = Percent Change in Sales ( or volume )

Or

Degree of Combined Leverage = Degree of Operating X Degree of Financial

Leverage Leverage

Or

Degree of Combined Leverage=

 Q auw taO h n pi tc ei ht r y a t i n g
L ei c sv o e mr a p xg u e t (ep Pdr u i −eVcn r eiac t por u ies) na rt ib t l e
 Q auw t aO h n pi tc ei ht r y a t i n g 
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 
Implication:

1. Remember that a firm with high leverage(s) will have large increases in EPS for
changes in sales but will also have large decreases in EPS for decreases in sales (and
therefore have high risk).

2. Firms that have lower leverage(s), with have smaller increases in EPS for the same
change in sales and will have smaller decreases in EPS for the same decrease in sales
(and therefore have lower risk).