INTRODUCTIONLeverage analysis The dictionarymeaning of the firm leverages refers to“an increase means of accomplishingpurpose “. In machines , leveragesmeans the instrument that helps us inlifting heavy objects, which may not beother wise possible. This concept ofleverage is valid in business too. Infinancial management , it is used todescribe the firms ability to use fixedassets costs funds to satisfy to magnifyto return of its owners.
Lifting Lever Increase the earningsFalcrum Fixed Cost Fund
DEFINATION :“ Leverage is the ratio of the net rate of return on shareholder equity and net rate of return on total capitalization.”
Types of leverage :There are three types of leverages-Financial leverageOperating leverageComposite leverage
Financial leverage“Financial leverage exists whenever a firm has debts other sources of funds that carry fixed charges “
Financial leverage A firm needs funds so run and manage its activities. The funds are first needs to set up an enterprise and then to implement expansion , diversification and other plans . A decision has to be made regarding the composition of funds. The funds may be raised through two sources., owners, called owners equity , and outsiders, called creditors equity.
Computation of financial leverageWhere capital structure consists of equity sharesand debts- financial leverage- EBIT or EBIT EBIT-INT EBT or OP EBT or PBTWhere the capital structure consists of preferenceshare and equity shares F.L- EBIT EBIT-(PDx1 ) 1-t
Computation of financial leverageWhen the capital structure consists of equity shares ,preference shares and debts FL- EBIT EBIT-INT-(PDx 1 ) 1-tDegree of financial leverage : DFL- %change in EPS % change in OP or EBIT
Importance of financial leverage1. Capital structure.2. Management Maximization of EPS and market value of shares.3. Measurement of Risk.
Operating leverageThis leverage is associated with theemployment of fixed cost assets. It iscalculated to know income of the company ondifferent levels of sales. It is measure of effecton operating profit of the concern on changein sales.
According to Solomon Ezra“Operating leverage is the tendency of theoperating profit to vary disproportionately with sales.”
Computation of Operating leverage OL= C OP or EBIT Contribution= Sales-Variable cost Operating profit= Contribution-Fixed costDegree of operating leverageDOL= % Change in OP or EBIT % Change in Sales
Composite leverage Composite leverage is calculated to determine the combined effect of operating and financial leverages. CL= Financial leverage x Operating Leverage or C PBTDegree of combined leverageDCL= % change in EBT % change in Sales