FINANCIAL AND OPERATING LEVERAGES
OPERATING LEVERAGE : Meaning
Operating leverage is the relationship between the rate of change that takes place in sales
and the resulting rate of change in net operating income. In other words, the degree of
operating leverage indicates the magnification of a change in sales upon the resulting
change in net operating income.
Operating leverage occurs when a change in the level of Sales causes a disproportionately
larger change in the operating profits. Operating leverage results because of the existence
of the fixed costs in the total operating costs of the concern; which do not change with
change in the volume of sales and causes a disproportionately larger change in the
operating profits consequent upon the change in the level of sales. In other words,
operating leverage depends upon the extent of commitment of fixed cost in the operating
activities of the concern. When a firm has heavy commitment to fixed costs in the total
operating costs, then it is using the force of fixed costs for magnifying its earnings, whereby
operating leverage comes into play. Operating leverage means heavy fixed assets usage. If
all the operating costs are variable then the degree of operating costs that is fixed, the
greater will be the degree of operating leverage.
Operating leverage is calculated as follows :
Sales – Variable Costs Contribution
Operating leverage = --------------------------- =----------------
Operating Profit Op. profit
Situation A Situation B
Sales 15,000 18,000
Variable costs 7,500 9,000
Contribution 7,500 9,000
Fixed Cost 6,000 6,000
Operating Profit 1,500 3,000
Contribution 7,500 9,000
Operating leverage =--------------- ------- -------
Op. profit 1,500 3,000 = 5
This means that in case of situation A – 1% increase in sales will result in 5% increase in
profits, where in case of situation B - 1% increase in sales will be accompanied by 3%
increase in profit. In other words, it means that if the sales of situation n A increases by
20%, the profits will increase by 100%, where in case of situation B; if the sales increase by
20%, the profits will increase by 60%.
Degree of Operating Leverage
Degree of operating leverage is the percentage change in operating income due to a
percentage change in units sold or sale revenue. It is computed as follows:
Percentage change in operating Income
DOL = ------------------------------------------------
Percentage change in volume
Conditions for operating of operating leverage
(i) Operating leverage magnifies not only return but also risk. Only when the risk is
matching with the acceptable return, it may prove beneficial to the firm.
(ii) There is a direct relationship between the breakeven point and the degree of
operating leverage, the closer the level of sales or output to the breakeven point, the
higher the degree of operating leverage. When the BEP increases, the degree of
operating leverage also increase.
Significance of Operating Leverage
(i) Relevance in capital budgeting decision : Operating leverage has an important role
to play in capital budgeting decision and long-term profit planning, since it involves
fixed cost. Capital begetting is concerned with long-term commitment of funds which
affects the profitability in the long run.
(ii) In planning capital structure : Since operating income is the basis for decision about
the capacity of the firm to bear the burden of payment of interest on debts and
repayment of certain portion of debts, operating leverage influences the debt-equity
mix or capital structure planning. Operating leverage affects EBIT, and through its
impact on EBIT it also affects capital structure planning.
Limitation of the Operating Leverage
(i) The basic limitation of the use of operating leverage concept is that it is based on the
assumption that the fixed costs are constant regardless of volume of sales; which
may not always hold good and therefore to some extent unrealistic.
(ii) Since it is based on the Break even analysis; all the limitations of BEP analysis will also
Financial Leverage : Meaning
Financial leverage is defined as the use of fixed cost capital in the total capitalisation of the
business concern. In other word, it is the tendency of the residual net income to vary
disproportionately with the operating profit. Financial leverage results from the fixed
financial costs. The capital structure of a company comprises of funds raised from the
shareholders as well as lenders of long –term funds. Fixed cost capital consists of loans,
debentures and preference share capital. Loans and debentures carry fixed obligations of
interest payments, where as preference shares are issued with fixed rate of dividend. Fixed
charges by way of interest on the long term loans will have to be paid at a pre-determined
rate, regardless of the quantum of earnings. If the return on investment is higher than the
rate of interest payable on the long term funds, the shareholders will stand to gain in view
of disproportionately higher residual earnings, thereby bringing financial leverage into play.
Financial leverage further magnifies the effect of changes in net operating income of the
firm upon income of the owners. If all operating assets of a business were financed by the
owners equity and thus there were no fixed financial costs, the degree of financial leverage
would be one. A given change in the net operating income would result in the same relative
change in income of the owners. However, part of the asset requirement may be financed
by borrowing, committing the firm to pay fixed interest charges or by issuing preference
shares incurring a limited obligation to pay dividends. These fixed or limited financial
commitments will result in a magnification of the effect of change in net operating income
upon the returns that finally comes to the owners.
Financial leverage can be calculated as follows:
Earnings before interest and tax
Financial leverage = --------------------------------------
Earnings before tax
The capital structure of a company consists of as follows :
Equity share capital 6,00,000
12% Debentures 4,00,000
If the earnings before interest and tax (EBIT) is Rs.2,00,000.
Interest on debentures will work to Rs. 48,000
Earnings before interest and tax
Financial leverage = ----------------------------------------
Earnings before tax
= ---------- = 1.32
This shows that an increase of 1 per cent in operating profits will cause an increase of 1.32
per cent in residual net income.
Degree of Financial Leverage
Degree of Financial leverage measures of the effect of percentage change in operating
income or EBIT on the percentage change in earnings available to the equity shareholders.
The following formula can be used to measure the degree of financial leverage.
Percentage change in EBIT
Degree of Financial leverage = --------------------------------
Percentage change in EPS
EBIT = ------
Conditions for operation of Financial Leverage :
The following are relevant for operation of financial leverage:
(i) The capital structure must consist of fixed cost capital. This means that a portion of
the fixed assets must be financed through fixed cost capital such debentures, loans
and preference share capital.
(ii) The return on investment must be greater than the fixed cost charges for the
profitable operation of financial leverage. In other words, the return on investment
must be higher than the interest percentage on loans or percentage dividend on
preference share capital.
(iii) The shareholders must be prepared to bear the increased risks which results from
the use of financial leverage. The use Financial leverage shifts the burden of firm’s
business risk on its shareholders.
(iv) If the ROI is equal to the fixed cost charges, the use of financial leverage will neither
be beneficial nor harmful. If the ROI is lower than the rate of interest or rate of
preference share dividend, then the results will be negative.
Signature of Financial Leverage :
(i) Profit planning : Profit planning involves careful analysis of various possible levels of
sales and the resultant profitability. Financial leverage affects earnings per share
(EPS). Financial leverage is based on break even analysis and therefore, very useful
took in profit planning.
(ii) Capital structure planning : Financial leverage is concerned with suitable mix of debt
and equity in the capital of the concern. There must be a proper balance between
debt and equity capital; which is achieved through financial leverage.
Limitations of Financial Leverage :
(i) If debt financing is not carefully handled, it may prove to be detrimental to the
growth of the firm. A large proportion of the debt content in the capital will pose a
great financial risk for the firm. Long-term lenders of money may raise the average
interest rate and may impose undue restrictions on the operations of the concern.
(ii) The price of the share may be come down in view of the fact that the shareholders
may conceive increased risk due to high debt financing. It may affect in maximizing
the overall value of the firm in the market.
Combined Leverage :
The operating leverage magnifies the effect of change in sales volume upon the net
operating income; whereas the Financial leverage magnifies that change in its effect upon
the income of the owners. Therefore,
Total leverage = Operating leverage x Financial leverage
If the degree of operating leverage is relatively high, the owners of the firm may not wish to
further magnify the effect of fluctuation in sales volume by multiplying it through the use of
financial leverage. Conversely, if the degree of operating leverage is low, the owners may
wish to seek higher returns through favourable financial leverage by obtaining a
considerable portion of the required funds through fixed return financing arrangements
such as debt, etc. Basically, decisions relating to both operating leverage and financial
leverage involve weighing the risks versus the expected returns in seeking to maximise the
value of the owner’s equity. Therefore combined leverage which is cumulative effect of
changes in sales volume upon the earning to the owners of the firm, is the product of
operating leverage and financial leverage.
Problem 1 :
An analytical statement of AB company is shown below: It is based on an output (Sales)
level of 80,000 unit
Variable cost 5,60,000
Revenue before fixed costs 4,00,000
Fixed costs 2,40,000
Earnings before tax 1,00,000
Net Income 50,000
Calculate the degree of (i) Operating Leverage (ii) Financial leverage and (iii) Combined
leverage from the above data.
Problem 2 :
(i) Find the operating leverage from the following data :
Sales Rs. 50,000
Variable Cost 60%
Fixed Cost Rs. 12,000
(ii) Find the financial leverage from the following data
Net worth Rs.25,00,000
Interest Rate 12%
Operating Profit Rs.20,00,000
The capital structure of the Progressive corporation consists of an ordinary share capital of
Rs.10,00,000 (share of Rs.100 per value) and Rs.10,00,000 of 10% Debentures, sales
increased by 20% from 1,00,000 units to 1,20,000 units, the selling price is Rs.10 per unit;
variable costs amount to Rs.6 per unit and fixed expenses amount to Rs.2,00,000. The
income-tax rate is assumed to be 50%.
(a) You are required to calculate the following :
(i) The percentage increase in earnings per share
(ii) The degree of financial leverage at 1,00,000 units and 1,20,000 units
(iii) The degree of operating leverage at 1,00,000 units and 1,20,000 units
(b) Comment on the behaviour of operating and financial leverages in relation to
increase in production from 1,00,000 units to 1,20,000 units.
Problem 4 :
(a) Calculate degree of operating leverage, degree of financial leverage and combined
leverage from the following data :
Sales 1,00,000 units at Rs.2 per unit is Rs.2,00,000
Variable cost/unit -Rs. 0.70, Fixed costs : Rs.1,00,000 , Interest Charges :Rs.3,668
(b) Which combination of operating and financial leverages constitute :
(i) Risky situation and (ii) ideal situation
Calculate operating, financial and combined leverage under Financial Plan X and Financial
Plan Y when the fixed costs are Rs.50,000 and Rs.1,00,000 in two different situations. The
information regarding capital structure and other data are as follows :
Total Assets 5,00,000
Total Assets turn over based on
Variable cost as percentage of
X (Rs.) Y (Rs.)
Equity 5,00,000 1,00,000
10% Debenture 1,00,000 5,00,000
ABC Ltd. has an average selling price of Rs.150 per unit. Its variable unit cost is Rs.105 and
fixed cost amount to Rs. 25 lakhs. It finances all its assets by equity funds. It pays 35% tax
on its income. XYZ Ltd. is identical to ABC Ltd., except in respect of the pattern of financing.
The latter finances its assets 50% by equity and 50% by debt, the interest on which amount
Determined the degree of operating financial and combined leverage at Rs.1,05,00,000
sales for both the firms.
From the following information of companies M and N, prepare their income statement:
COMPANY M COMPANY N
Variable costs as % of
Interest Rs.2,00,000 Rs.6,00,000
Degree of operating
Degree of financial
Income tax Rate 35% 35%