Meaning

Leverage allows us to accomplish certain things which are otherwise not possible, lifting of heavy objects with the help of leverage. In financial management, the term leverage is used to describe the firms ability to use fixed cost assets or funds to increase the return to its owners.
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Types of leverage
Operating Leverage Financial Leverage Combined Leverage

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Operating Leverage
Operating leverage is the study of the impact of fixed cost on the earnings of the firm. Presence of fixed cost magnifies earnings of the firm. Earnings are
better under favourable business conditions, and poorer if conditions are unfavourable.

as compared to firms with no or smaller fixed cost.

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Operating Leverage
Operating Leverage = Contribution/ operating profits Contribution = Sales- variable cost
Operating Profit = Sales- Variable cost- fixed cost Break even point= Fixed cost/ P.V ratio P.V ratio = Contribution / sales
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Degree Of Operating Leverage

Degree of Operating Leverage (DOL) is a relationship between the % change in EBIT with 1% change in sales.

The minimum value of DOL is 1.00 Larger the Degree of Operating Leverage larger is the change in earnings. This makes earnings riskier too. It is a measure of business risk

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Degree of Operating Leverage

Operating leverage affects a firms operating profit (EBIT).
% Change in EBIT % Change in Sales EBIT/EBIT DOL Sales/Sales DOL

The degree of operating leverage (DOL) is defined as the percentage change in the earnings before interest and taxes relative to a given percentage change in sales.

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Problem
Installed capacity= 1,000 units Operating capacity= 800 units Selling price per unit= Rs 10 Variable cost = Rs 7

Calculate operating leverage and DOL Fixed cost Situation A 800 Situation B 1200 Situation C 1500
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Practical Problem
Following is the cost information of a firm. Fixed cost = Rs 50000 Variable cost = 70 % of sales. Sales Rs. 2,00,000 in pervious year and Rs, 2,50,000 in current year. Find out Degree of operating leverage.

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Financial leverage
Firm can use two types of sources of finance called owners equity and creditors equity. The use of long term interest bearing debt and preference share capital along with equity capital is called financial leverage or trading on equity. The long term fixed interest bearing debt is employed by a firm to earn more from the use of these resources than their cost so as to increase the return on owners equity.

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Financial leverage
A firm is known to have a favourable leverage if its earnings are more than what debt would cost. On the contrary, if it does not earn as much as the debt costs then it will be known as an unfavourable leverage.

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Degree of Financial Leverage

The degree of financial leverage (DFL) is defined as the percentage change in EPS due to a given percentage change in EBIT:

DFL= EBIT/ EBIT-I

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Practical problem
A ltd. Company has equity share capital of Rs. 5,00,000 divided into shares of Rs. 100 each. It wishes to raise further Rs. 3,00,000 for expansion plans. The company has the following alternatives. All common stock Rs 1 lakh in common stock and Rs 2 lakh in 10% debenture. All debt at 10%. Rs 1 Lakh in common stock and Rs. two lakhs in Preference capital with the rate of dividend @ 8 %. the companys existing EBIT are Rs. 1,50,000. the corporate tax is 50%. You are required to determine the EPS and comment on the same.
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Practical Problem
A company has currently an equity share capital of Rs. 40 Lakh consisting of 40,000 equity shares of Rs 100 Each. The management is planning to raise another Rs 30 Lakh to finance a major programme of expansion through one of four possible financing plans. EBIT= 15 Lakhs, corporate tax is 50%. Entirely through equity shares. Rs 15 lakh in equity shares of Rs 100 each and the balance in 8% Debentures. Rs 10 Lakh in equity shares of Rs 100 each and the balance through long term borrowings at 9%. Rs 15 Lakh in equity shares of Rs 100 each and the balance through preference shares with 5%.
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Combining Financial and Operating Leverages

Operating leverage affects a firms operating profit (EBIT), while financial leverage affects profit after tax or the earnings per share.
The degrees of operating and financial leverages is combined to see the effect of total leverage on EPS associated with a given change in sales.

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Combining Financial and Operating Leverages

The degree of combined leverage (DCL) is given by the following equation:
% Change in EBIT % Change in EPS % Change in EPS % Change in Sales % Change in EBIT % Change in Sales

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Combined/Total Leverage
Degree of Total Leverage (DTL) is the study of impact of changing level of sales on the EPS. It is the product of DOL and DFL. It is measure of combined risk.
DTL = = % change in EPS % change in Sales % change in EPS % change in EBIT x % change in EBIT % change in Sales Sales - Variable cost EBIT x EBIT EBIT- Interest Contribution EBIT - Interest

= DFL x DOL DTL = =

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Practical problem
A company has sales of Rs. 5,00,000, variable cost of Rs 3,00,000, fixed cost of Rs. 1,00,000 and long term loans of Rs. 4,00,000 at 10% rate of interest. Calculate the composite leverage.

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Practical problem
P Ltd. Sales Variable cost Fixed cost Interest 500 200 150 50 Q Ltd. 1000 300 400 100

Calculate the operating, financial and combined leverage and comment upon them.

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Practical problem
Installed capacity 2000 units Annual production and sales 50% of installed Selling price per unit Rs 20 Variable cost per unit Rs 10 Fixed cost Situation 1 4000 Situation 2 5000 Financial plan A- Equity 5000, Debt cost @10%- 15000 Financial plan B equity 15000, Debt cost @10%- 5000 Calculate operating and financial leverage under situation 1 and 2 and financial plan A and B.
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