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FINANCIAL AND OPERATING LEVERAGES
OPERATING LEVERAGE : Meaning
Operating leverage is the relationship between the rate of ...
Op. profit 1,500 3,000 = 5
= 3
This means that in case of situation A – 1% increase in sales will result in 5% increase in...
(i) The basic limitation of the use of operating leverage concept is that it is based on the
assumption that the fixed cos...
Illustration :
The capital structure of a company consists of as follows :
Equity share capital 6,00,000
12% Debentures 4,...
(i) The capital structure must consist of fixed cost capital. This means that a portion of
the fixed assets must be financ...
The operating leverage magnifies the effect of change in sales volume upon the net
operating income; whereas the Financial...
Problem 2 :
(i) Find the operating leverage from the following data :
Sales Rs. 50,000
Variable Cost 60%
Fixed Cost Rs. 12...
Problem 5:
Calculate operating, financial and combined leverage under Financial Plan X and Financial
Plan Y when the fixed...
Unit 8   leverage -fin & oprt
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Unit 8 leverage -fin & oprt

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Unit 8 leverage -fin & oprt

  1. 1. 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 Illustration : Situation A Situation B Rs. Rs. 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 =--------------- ------- -------
  2. 2. Op. profit 1,500 3,000 = 5 = 3 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
  3. 3. (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 apply. 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
  4. 4. Illustration : The capital structure of a company consists of as follows : Equity share capital 6,00,000 12% Debentures 4,00,000 10,00,000 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 2,00,000 = ---------- = 1.32 1,52,000 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 = ------ EBIT-I Conditions for operation of Financial Leverage : The following are relevant for operation of financial leverage:
  5. 5. (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 :
  6. 6. 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. IILUSTRATED PROBLEMS Problem 1 : An analytical statement of AB company is shown below: It is based on an output (Sales) level of 80,000 unit Rs. Sales 9,60,000 Variable cost 5,60,000 Revenue before fixed costs 4,00,000 Fixed costs 2,40,000 1,60,000 Interest 60,000 Earnings before tax 1,00,000 Tax 50,000 Net Income 50,000 Calculate the degree of (i) Operating Leverage (ii) Financial leverage and (iii) Combined leverage from the above data.
  7. 7. 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 Debt/Equity 3/1 Interest Rate 12% Operating Profit Rs.20,00,000 Problem 3: 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
  8. 8. Problem 5: 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 : Rs. Total Assets 5,00,000 Total Assets turn over based on sales 2 Variable cost as percentage of Sales 60 Financial Plan X (Rs.) Y (Rs.) Equity 5,00,000 1,00,000 10% Debenture 1,00,000 5,00,000 Problem 6: 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 Rs.3,00,000. Determined the degree of operating financial and combined leverage at Rs.1,05,00,000 sales for both the firms. Problem 7: From the following information of companies M and N, prepare their income statement: COMPANY M COMPANY N Variable costs as % of Sales 75 70 Interest Rs.2,00,000 Rs.6,00,000 Degree of operating leverage 3-14 5-1 Degree of financial leverage 2-1 3-1 Income tax Rate 35% 35% ***

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