Leverages _Vol-II_CA. Dr. Prithvi Ranjan Parhi

Volume-II
Leverages
CA. Dr. Prithvi Ranjan Parhi
5:11 PM © CA. Dr. Prithvi Ranjan Parhi 1
“…Give me a place to stand, and I will move the earth.”
- Archimedes (287-212 BC)

2
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
5:11 PM

3
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
EPS (= PAT/ No of Equity Shares) XXX
OL
FL
CL
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4
Q1
Sales 10,000 units.
Sale price Rs.20 p.u.
Variable Cost = Rs.12/- p.u.
Fixed Cost = Rs,20,000/-
Interest Rs.10,000/-
Rate of Tax 30%
Prepare income statement & Compute 3
leverages
5:11 PM

5
A-1
Particulars (Rs)
Sales (10,000 *20) 2,00,000
Less : VC (10,000 * 12) (1,20,000)
Contribution 80,000
Less: FC (20,000)
PBIT 60,000
Less: Interest (10,000)
PBT 50,000
Tax (30%) (15,000)
PAT 35,000
Degree of OL = Cont/ PBIT = 80,000/60,000 = 1.33 Times
Degree of FL = PBIT/ PBT = 60,000/50,000 = 1.2 Times
Degree of TL = Cont/ PBT = 80,000/50,000 = 1.60 Times
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6
Q-2
• In the previous question if the total asset
of the company is Rs.35,00,000,
represented by 3,500 shares of 1,000
each, what is the EPS ?
• What will be the EPS if Sales volume,
a) increases by 10%
b) decreases by 10% ?
5:11 PM

7
A-2
1.6 %
1.33 %
1.6 %
Particulars Present
(Rs.)
Sales 10%
more (Rs.)
Sales 10% less
(Rs.)
Sales 2,00,000 2,20,000 1,80,000
Less : VC (1,20,000) (1,32,000) (1,08,000)
Contribution 80,000 88,000 72,000
Less: FC (20,000) (20,000) (20,000)
PBIT 60,000 68,000 52,000
Less: Interest (10,000) (10,000) (10,000)
PBT 50,000 58,000 42,000
Tax (30%) (15,000) (17,400) (12,600)
PAT 35,000 40,600 29,400
No. of Sh 3,500 3,500 3,500
EPS 10 11.6 8.4
13.33 %
10 %
Degree of OL = Cont/ PBIT = 1.33 Times
Degree of FL = PBIT/ PBT = 1.2 Times
Degree of TL = Cont/ PBT = 1.60 Times
Note : Leverages are not static, in so far as they change with every change
in income statement
16 %
16 %
© CA. Dr. Prithvi Ranjan Parhi5:11 PM

8
Leverage : Effects
• Use of special forces and effects to magnify
or produce more than the normal results
from a given course of action.
– Can produce beneficial results in favorable
conditions.
– Can produce highly negative results in
unfavorable conditions.
5:11 PM

9
“POSITIVE” & “NEGATIVE” LEVERAGE
Leverage
Positive leverage Negative leverage
When more debt
will increase the
equity investor’s
(borrower’s) return.
When more debt
will decrease the
equity investor’s
(borrower’s) return.
5:11 PM

Difference between OL & FLSl. Operating Leverage Financial Leverage
1 Operating leverage is associated with
investment activities of the company.
Financial leverage is associated with
financing activities of the company.
2 Operating leverage consists of fixed operating
expenses of the company.
Financial leverage consists of Fixed
Financial Expenses of the company.
3 It represents the ability to use fixed operating
cost.
It represents the ability to use fixed
financial cost.
4 Operating leverage can be calculated by=
Contribution/EBIT
Financial leverage can be calculated by=
EBIT/EBT
5 A percentage change in the profits resulting
from a percentage change in the sales is called
as degree of operating leverage.
A percentage change in taxable profit is the
result of percentage change in EBIT.
6 Trading on equity is not possible by using
operating leverage
Trading on equity is possible only when the
company uses financial leverage.
7 Operating leverage depends upon fixed cost
and variable cost.
Financial leverage depends upon the
operating profits & fixed financial costs.
8 Tax rate and interest rate will not affect the
operating leverage.
Financial leverage will change due to tax
rate and interest rate.
5:11 PM
10

Trading on Equity
• It is a financial process that involves taking more
debt to boost the return of the shareholders.
• Trading on Equity occurs when a company takes
new debt, in the form of bonds, preferred stock, or
loans etc.
• So, the company basically takes advantage of
the equity to borrow funds on reasonable terms.
5:11 PM
© CA. Dr. Prithvi Ranjan Parhi 11

12
Summary
• Leverage is using fixed costs to magnify the
potential return to a firm
• 2 types of fixed costs:
– fixed operating costs = rent, depreciation
– fixed financial costs = costs from debt, preference
dividend etc.
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13
Leverage Means Risk
• Leverage is a double-edged sword.
• It magnifies profits as well as losses.
• An aggressive or highly leveraged firm has high
fixed costs (and a relatively high break-even point)
• A conservative or non-leveraged firm has low fixed
costs (and a relatively low break-even point)
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14
Break-Even (BE) Point
• Quantity where Total Revenue equals Total Cost
• Company has no Profit or Loss
• BE = Fixed Costs / (Price – Variable Costs)
• A leveraged firm has a high BE point
• A non-leveraged firm has a low BE point
5:11 PM

15
Break-even chart: Leveraged firm
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16
Break-even chart: Un-leveraged firm
5:11 PM

17
• Higher operating leverage leads to more
business risk, because a small sales decline
causes a larger EBIT decline.
Sales
$ Rev.
TC
F
QBE Sales
$ Rev.
TC
F
QBE
EBIT}
Leverage ~ Risk
5:11 PM

18
Thank you
CA. Dr. Prithvi Ranjan Parhi
Mail: prithvi.baps@gmail.com
WhatsApp :876 3434 746
Cell: 700 8246 670
5:11 PM

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