Operating Leverage, Financial Leverage and Total Leverage

1. Volume-I
Leverage
CA. Dr. Prithvi Ranjan Parhi
4:51 PM ©CA. Dr.. Prithvi Ranjan Parhi 1
“…Give me a place to stand, and I will move the earth.”
- Archimedes (287-212 BC)

2. 2
Financial Leverage...
Rs4,00,000
EQUITY
INVESTMENT
Can buy
Rs.10,00,000
PROPERTY
"Leverage Ratio" = Rs10,00,000 / Rs.4,00,000 = 2.5
Equity = Rs.4,00,000/-
Debt = Rs.6,00,000/-
©CA. Dr.. Prithvi Ranjan Parhi
4:51 PM

3. 3
Analogy of physical leverage & financial leverage...
20 Kg
10 Kg
A Physical Lever...
"Leverage Ratio" = 20/10 = 2.0
10 kg, if levered, can lift 20 kg.
Debt at 10%, if levered can earn 15%
LIFTS
4 feet
2 feet
©CA. Dr.. Prithvi Ranjan Parhi
4:51 PM
Kd
=10%
RoI
=15%

4. 4
Importance Leverage
Managers A B
Total Capital 200 200
Equity 100 200
8% Debenture / Bond 100 0
% Return on investment 10% 10%
In Rs 20 20
(-) Interest (8) (0)
Money available for share holders 12 20
Dividend 12% 10%
©CA. Dr.. Prithvi Ranjan Parhi
4:51 PM

5. 5
Importance of Leverage
Managers A B
Total Capital 200 200
Equity 100 200
12 % Debenture / Bond 100 0
% Return on Investment 10% 10%
In Rs 20 20
(-) Interest (12) (0)
Money available for share holders 8 20
Dividend 8% 10%
©CA. Dr.. Prithvi Ranjan Parhi
4:51 PM

6. 6
Importance Leverage
Managers A B
Total Capital 200 200
Equity 100 200
10% Debenture / Bond 100 0
% Return on Investment 10% 10%
In Rs 20 20
(-) Interest (10) (0)
Money available for share holders 10 20
Dividend 10% 10%
©CA. Dr.. Prithvi Ranjan Parhi
4:51 PM

7. 7
Leverage : Meaning
• The term “ Leverage” has been borrowed from physical
science where lever means a device by which heavy
objects are lifted with small force.
• It generally refers to a relationship between 2 variables.
• In financial analysis it refers to influence of 1 financial
variable over some other related variables. Eg. EBIT,
EPS
• Leverage is using fixed costs to magnify the potential
return to a firm.
©CA. Dr.. Prithvi Ranjan Parhi
4:51 PM

8. 8
Leverage
• Leverage leads to rewards being
disproportionate to efforts.
• Reward means profit or EPS.
• Effort means Sales.
• If sales goes up by 10% & profit increases by
50%, it means rewards are disproportionate to
effort.
©CA. Dr.. Prithvi Ranjan Parhi
4:51 PM

9. 9
Leverage
• The existence of fixed cost in a Co’s cost
statement leads to leverage.
• These fixed costs may be,
2 types of fixed costs
Fixed operating costs Fixed financial costs
Fixed cost of the product,
rent, depreciation
Fixed cost of the Source of finance
Interest costs from debt
4:51 PM
©CA. Dr.. Prithvi Ranjan Parhi

10. 10
X
Total Leverage
or
Combined Leverage
Operating Leverage Financial Leverage
Due to existence of
Fixed cost
In the products cost
structure
Due to existence of
Fixed charges in
Sources of finance
in the Co’s capital
structure
Contribution
PBIT
PBIT
PBT
Contribution
PBT
©CA. Dr.. Prithvi Ranjan Parhi
4:51 PM

11. 11
Total Leverage
• Total Leverage is a product of Operating
Leverage & Financial Leverage
• Total Leverage = Contribution X PBIT
PBIT PBT
= Contribution
PBT
©CA. Dr.. Prithvi Ranjan Parhi
4:51 PM

12. 12
Risk
Risk in any business arises on a/c of fixed cost represented
by degree of operating leverage & interest on loans
borrowed, represented by degree of financial leverage
Risk
Fixed Cost
( Operating)
Interest
Combined
Fixed Cost
Degree of
Operating Leverage
Degree of
Financial Leverage
Degree of
Combined Leverage
Contribution
PBIT
PBIT
PBT
Contribution
PBT
©CA. Dr.. Prithvi Ranjan Parhi
4:51 PM

13. 13
Leverage Structure
Sales XXX
Less: Variable Cost (XXX)
Contribution XXX
Less : Operating Fixed Cost (XXX)
PBIT XXX
Less : Interest (XXX)
PBT XXX
Less : Tax (XXX)
PAT XXX
OL
FL
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CL
4:51 PM

14. 14
Operating Leverage
• OL is measured in terms of “Times”.
• OL measures the change in PBIT for every
change in Sales (i.e. Contribution).
• E.g. If OL is 3 and Sales changes by 10%,
PBIT will change by 10 x 3 = 30%
©CA. Dr.. Prithvi Ranjan Parhi
4:51 PM

15. 15
Financial Leverage
• FL is measured in terms of “Times”.
• FL measures the change in PBT or EPS for
every change in PBIT.
• E.g. If FL is 2 and PBIT changes by 30%,
PBT will change by 30 x 2 = 60%
©CA. Dr.. Prithvi Ranjan Parhi
4:51 PM

16. 16
Total Leverage
• TL is measured in terms of “Times”.
• TL measures the change in PBT or EPS for
every change in Sales.
• E.g. If TL is 6 and Sales has increased by
10%, Profit or EPS should increase by 10 x
6 = 60%
©CA. Dr.. Prithvi Ranjan Parhi
4:51 PM

17. 17
Leverage Management
• A high Total Leverage is risky since it bring about
disproportionate change in rewards.
• Often Operating Leverage is not within the control of
management and would depend on the nature of the
product.
• Hence when a product has a high operating leverage, the
firm seeks to maintain a low Financial Leverage, so that
the Total Leverage is moderate.
• Similarly, if OL is low, firm tries to keep high FL so that TL
will be moderate.
©CA. Dr.. Prithvi Ranjan Parhi
4:51 PM

18. 18
Leverage Analysis
OL FL TL
High High High
High Low Moderate
Low High Moderate
Low Low Low
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19. 19
Thank you
CA. Dr. Prithvi Ranjan Parhi
Mail: prithvi.baps@gmail.com
WhatsApp :876 3434 746
Cell: 700 8246 670
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4:51 PM