Simple Explanation Of Operating Leverage & Financial Leverage

1. SOURCES OF CAPITAL ON THE
BASIS OF OWNERSHIP &
LEVERAGES
PRESENTED BY:AKHITATAYAL & RAHUL BISEN

2. SOURCES OF CAPITAL
 Sources of finance for business are equity,
debt, debentures, retained earnings, term
loans etc.These sources of funds are used in
different situations.They are classified based
on time period, ownership and control, and
their source of generation.
 Today we are going to discuss only about
sources of capital based on ownership and
control.

3. Ownership And Control
 These are the two most important
consideration while selecting a source of
funds for the business.Whenever we bring in
capital, there are two types of costs – one is
the interest and another is sharing ownership
and control.
 Ownership and control classify sources of
finance into owned and borrowed capital.

4. Owned Capital
 Owned capital is also known as
equity/owner’s fund. It is sourced from
promoters of the company or from the
general public by issuing new equity shares.
 Who are Promoters?
Promoters start the business by bringing in
the required money for a startup.

5. Sources of owned capital
 1. EquityCapital: Equity or shares are a unit of ownership in
a company, and equity capital is raised by issuing shares to
shareholders. It is also referred to as share capital
 Equity capital is also called as residual capital.This means
that shareholders have last right on the assets of a
company.
 The equity capital of a company is not constant as it keeps
changing due to various corporate events, such as a rights
issue and additional issuance of shares.

6. 2. Preference capital
 2. PreferenceCapital:The Preference
Capital is that portion of capital which is
raised through the issue of the preference
shares.This has certain characteristics of
equity and certain attributes of debentures.
 Shareholders with these shares must
be paid before those with equity shares when
a company is paying dividends or if it
goes bankrupt

7. 3. Retained Earnings(RE)
 Retained earnings (RE) is the amount of net
income left over for the business after it has
paid out dividends to its shareholders. A
business generates earning that can be
positive (profits) or negative (losses)
 Retained Earnings= Beginning Period RE+
Net income (or loss)- Cash dividends- Stock
Dividends.

8. Retained Earnings(Cont’d)
 Often the profit earned by a company is paid
out to shareholders, but it can also be
reinvested back into the company for growth
purposes.The money not paid to
shareholders counts as retained earnings.
 The decision to retain the earnings or to
distribute it among the shareholders is
usually left to the company management.

9. 4. Convertible Debentures
 A convertible debenture is a kind of long-
term debt which can be transformed into
stock after a certain period of time.
 A convertible debenture is usually an
unsecured bond or a loan as in there is no
primary collateral interlinked to the debt.

10. Convertible
Debentures(cont’d)
 Some companies may use more debt than
equity to raise capital .
 The option of converting debentures into
equity shares lies with the holder.
 A convertible debenture will provide regular
interest income via coupon payments and
repayment of the principal amount at
maturity.

11. 5. Venture Capital Fund
 Venture capital (VC) is a form of private
equity and a type of financing that investors
provide to startup companies and small
businesses that are believed to have long
term growth potential.
 It does not always take a monetary form; it
can also be provided in the form of technical
or managerial expertise.

12. Advantages of owned capital
 It is a long-term capital which means it stays
permanently with the business.
 There is no burden of paying interest or
installments like borrowed capital. So, the
risk of bankruptcy also reduces. Businesses in
infancy stages prefer equity for this reason.

13. Disadvantages of Owned
Capital
 The cost of equity capital is high since the
equity shareholders expect a higher rate of
return.
 The cost of issuing equity shares is usually
costlier than the issue of other types of
securities.
 The cost of equity is relatively more, since the
dividends are paid out of profit after tax, but
the interest payments are tax-deductible.

14. Sources Of Borrowed Capital
 Borrowed or debt capital is the finance
arranged from outside sources.These sources
of debt financing include the following:
 Financial institutions,
 Commercial banks or
 Debentures

15. Let’s Understand Borrowed
Capital
 Borrowed capital can be in the form of loans,
credit cards, overdraft agreements, and the
issuance of debt, such as bonds.
 In all the cases, a borrower must pay an
interest rate as the cost of borrowing.
Typically, debt is secured by collateral.
 Borrowed capital may also take the form of a
debenture, however, and in that case, it is not
secured by an asset.

16. Advantages and Downside Of
Borrowing Capital
 There is no dilution in ownership and control of
the business.
 The cost of borrowed funds is low since it is a
deductible expense for taxation purpose which
ends up saving on taxes for the company.
 It gives the business the benefit of leverage.
 The downside is the potential for greater losses,
given that the borrowed money must be paid
back somehow, regardless of the investment's
performance.

18.  In General Terms, Leverage means the use of force and effects to
produce a more than normal results from a given action.
 In Other Words, Leverage is the advantage generated by using a
lever.
 Example, Using a Jack to Lift a Car.
 In Finance, Leverage is the use of fixed costs to magnify the
potential return to a firm.
 Two Types Of Fixed Costs :
 Fixed Operating Costs = Rent, Salaries, etc.
 Fixed Financial Costs = Interest Costs From Debt.

19.  Leverage Can Magnify Returns to Common Stockholders but can also
Increase Risk.
 Management has almost complete control over this risk introduced
through the use of leverage (fixed costs) .
 The Degree in the use of Leverage depends on management’s attitude
toward risk and the nature of its business, among others.
 Three types of Leverage with reference to the firm’s income statement:
1. Operating Leverage
2. Financial Leverage
3. Combined (Total) Leverage
 Leverage is measured on the profitability range of operations.

20.  Leverage is an essential tool a company's management can
use to make the best financing and investment decisions.
 It provides a variety of financing sources by which the firm
can achieve its target earnings.
 Leverage is also an important technique in investing as it
helps companies set a threshold for the expansion of
business operations.
 For example, it can be used to recommend restrictions on
business expansion once projected return on additional
investment is lower than cost of debt.
Leverage provides the following benefits for businesses:

21.  Operating leverage is a cost-accounting formula that measures the degree to
which a firm or project can increase operating income by increasing revenue.
 A business that generates sales with a high gross margin and low variable
costs has high operating leverage.
 A firm with relatively high fixed operating costs will experience more variable
operating income if sales change.
 Operating leverage is a cost-accounting formula that measures the degree to
which a firm or project can increase operating income by increasing revenue.
 Companies with high operating leverage must cover a larger amount of fixed costs
each month regardless of whether they sell any units of product.
 Low-operating-leverage companies may have high costs that vary directly with
their sales but have lower fixed costs to cover each month.

22. Operating Leverage can be calculated with the
help of the following formula:-
OL = Contribution/EBIT
Where,
 OL = Operating leverage
 EBIT = Earnings Before Interest & Taxes.

23. Characteristics of Operating
Leverage
 It is related to the assets side of balance
sheet.
 It is directly related to break-even point.
 It is related to selling price and variable
costs.
 It is involves business risk.

24.  The degree of operating leverage (DOL) is a financial ratio
that measures the sensitivity of a company’s operating
income to its sales.
 This financial metric shows how a change in the company’s
sales will affect its operating income.
 The degree of operating leverage (DOL) at any level of output
expressed as the ratio of the percentage change in operating
profits to percentage change in sales.

25.  The degree of operating leverage can be calculated in
several different ways.
1. First, we can use the formula from the definition of the
2. Since the operating leverage ratio is closely related to
the company’s cost structure, we can calculate it using the
company’s contribution margin. The contribution margin is
the difference between total sales and total variable costs.

26. 3. If there is available information about the cost structure of a
company, we can use the following formula:
Where:
•Q – the number of units
•P – the price per unit
•V – the variable cost per unit
•F – the fixed costs

27.  The management of ABC Corp. wants to determine the company’s current degree
of operating leverage. The company sells 10,000 product units at an average price
of $50. The variable cost per unit is $12, while the total fixed costs are $100,000.
The company’s DOL is:
The DOL indicates that every 1% change in the company’s sales will change the
company’s operating income by 1.38%.

29.  Operating leverage is one of the techniques to measure the impact of changes in
sales which lead for change in the profits of the company.
 If any change in the sales, it will lead to corresponding changes in profit.
 Operating leverage helps to identify the position of fixed cost and variable cost.
 Operating leverage measures the relationship between the sales and revenue of
the company during a particular period.
 Operating leverage helps to understand the level of fixed cost which is invested
in the operating expenses of business activities.
 Operating leverage describes the over all position of the fixed operating cost.

30.  Leverage activities with financing activities is called financial leverage.
 Financial leverage represents the relationship between the company’s earnings
before interest and taxes (EBIT) or operating profit and the earning available to
equity shareholders.
 Financial leverage is defined as “the ability of a firm to use fixed financial charges
to magnify the effects of changes in EBIT on the earnings per share”.
 It involves the use of funds obtained at a fixed cost in the hope of increasing the
return to the shareholders.
 The use of fixed-cost sources of financing (debt, preferred stock) rather than
variable- cost sources (common stock).

31. Financial Leverage can be calculated with the
help of the following formula:-
FL = OP/PBT
Where,
 FL = Financial leverage
 OP = Operating profit (EBIT)
 PBT = Profit before tax.

32. Characteristics of Financial
Leverage
 It is related to liabilities side of balance
sheet.
 It is the mix of methods of financing.
 It shows effect of changes in operating
profits on earnings per share due to fixed
financial charges.
 It involves financial risk.

33.  The degree of financial leverage is a financial ratio that
measures the sensitivity in fluctuations of a company’s overall
profitability to the volatility of its operating income caused by
changes in its capital structure.
 The degree of financial leverage is one of the methods used
to quantify a company’s financial risk (the risk associated with
how the company finances its operations).

34.  The degree of financial leverage can be calculated in
several different ways.
1. The choice of the calculation method depends on
the goals and context of the analysis. For example, a
company’s management often wants to decide
whether it should or should not issue more debt. In
such a case, net income would be an appropriate
measure of the company’s profitability:

35. 2. If an investor wants to determine the effects of the company’s
decision to incur additional leverage, the earnings per share (EPS) is a
more appropriate figure because of the metric’s strong relationship with
the company’s share price.
3. There is a formula that allows calculating the degree of
financial leverage in a particular time period:

36.  Suppose ABC Corp. is preparing to launch a new project that will require
substantial external financing. The company’s management wants to determine
whether it can safely issue a significant amount of debt to finance the new project.
Currently, the company’s EBIT is $500,000, and interest payments are $100,000.
In order to make the decision, the company’s management wants to examine its degree of
financial leverage ratio:
It shows that a 1% change in the company’s leverage will change the company’s operating income by
1.25%.

38.  Financial leverage helps to examine the relationship between EBIT and EPS.
 Financial leverage measures the percentage of change in taxable income to the
percentage change in EBIT.
 Financial leverage locates the correct profitable financial decision regarding capital
structure of the company.
 Financial leverage is one of the important devices which is used to measure the fixed
cost proportion with the total capital of the company.
 If the firm acquires fixed cost funds at a higher cost, then the earnings from those assets,
the earning per share and return on equity capital will decrease.