2. LeverageAnalysis
Leverage provides the Framework for Financing
Décisions of a Firm.
‘Leverage’ means ‘effectiveness’ or ‘power’
A firm is said to be leveraged if it has fixed cost
Degree of leverage -Measure of how much leverage the
firm uses
Deleveraging is the action of reducing borrowings.
3. OPERATING LEVERAGE
What is it? How is it Increased?
Operating leverage is:
• The increased volatility in operating income caused
by fixed operating costs.
Managers do make decisions affecting the cost
structure of the firm.
Managers can decide to invest in assets that give rise
to additional fixed costs in intention to reduce variable
costs.
Commonly accomplished by a firm choosing to
become more capital intensive and less labour
intensive, thereby increasing operating leverage.
4. Operating Leverage
Advantages and Disadvantages
Advantages:
• Magnification of profits to the shareholders if the firm is profitable.
• Operating efficiencies (faster production, fewer errors, higher quality)
usually result increasing productivity, reducing ‘downtime’ etc.
Disadvantages:
• Magnification of losses to the shareholders if the firm is not profitable.
Higher break even point
• High capital cost of equipment and the illiquidity of such an investment
make it:
Expensive (more difficult to finance) Potentially exposed to technological
obsolescence, etc.
5. Operating leverage
Operating leverage is a measurement of the degree to which a
firm incurs a combination of fixed and variable cost
Operating leverage=contribution/EBIT
contribution=sales –variable cost
EBIT = contribution –fixed cost
Note : in case the contribution exceeds the fixed cost, the operating
leverage is favorable. when C<F, the operating leverages is
unfavorable
6. Degree of operating leverage
It measures how much is the effect of change in sales on operating
profit.
The degree of operating leverage at any level is expressed in
percentage change in operating profit to percentage change in sales
Degree of operating leverage= % change in EBIT
% change in sales
7. Financial leverage
It is the tendency of the residual net income to vary disproportionately with
the operating profit. It indicate the changes that takes place in the taxable
income as a result of the change in the operating profit.
Financial leverage= EBIT
EBT
EBIT= Earning before interest and tax
EBT= I-EBIT ,
ie;earning before tax I = interest and preference divident
8. Degree of financial leverage
The degree of financial leverage is defined as the percentage change in EPS
due to the given percentage change in EBIT.
DFL = % change in EPS
% change in EBIT
10. Combined or Total leverage
It is the combination of operating and financial leverage
Both of these leverage are closely concerned with firms capacity to
meet its fixed cost & their combined effect will measure the firms
financial strength.
Combined leverage = operating leverage * financial leverage
11. Degree of combined leverage
It is calculated by multiplying the DOL and the DFL and it is
calculated by the formula
Degree of combined leverage =DOL * DFL
ie,= % change in EPS
% change in sale
