- Leverage provides the framework for financing decisions and can be defined as using an asset or source of funds that requires paying a fixed cost or return. - Operating leverage is associated with fixed operating costs and how much they magnify changes in sales on operating profits. Financial leverage measures how debt impacts changes in earnings per share. - Degree of operating leverage (DOL) and degree of financial leverage (DFL) are used to measure the sensitivity of profits and earnings to changes in sales and operating profits respectively. Higher leverage means greater risk but also greater potential returns.

1. ANALYSIS OF
LEVERAGE
TEAM :-
ISHA
S.YUSRA JAMAL
SAMRJEET KAUR

2. Introduction
• Leverage provides the Framework for
Financing Décisions of a Firm.
• It May Be définie as the Employment of an
Assest or Source of Funds for which the
Firm has to pay a Fixed Cost , or Fixed
Return.
• Deleveraging is the action of reducing
borrowings.
• A key measure of leverage is the debt to
GDP ratio.

4. Break-Even (BE) Point
• Quantity where Total Revenue equals Total
Cost
• Company has no Profit or Loss
• BE = FC / P – VC
• A leveraged firm has a high BE point
• A non-leveraged firm has a low BE point

5. Risk in the Context of
Leverage
• Leverage influences stock price
Alters the risk/return relationship in an equity
investment
• Measures of performance
Operating income (EBIT or Earnings Before Interest
and Taxes)
• Unaf f ect ed by leverage because it is
calculat ed prior t o t he deduct ion f or
int erest
Return on Equity (ROE) is Earnings after Taxes ÷
Stockholders’ Equity
Earnings per Share (EPS) is Earnings after Taxes ÷
number of shares
• I nvest ors regard EPS as an import ant
indicat or of f ut ure prof it abilit y

6. Risk in the Context of
Leverage
• Redefining Risk for Leverage-Related Issues
• Leverage-related risk is variation in ROE and
EPS:
1. Business risk—variation in EBIT
2. Financial risk—additional variation in ROE
and EPS brought about by financial leverage.
• 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)

7. Business and Financial
Risk

8. Operating Leverage
• It is associated with asset acquisition or investment
activities.
• It may be defined as the ability to use fixed operating costs
to magnify the effect of changes in sales on its operating
profits(EBIT).
• Refers to the amount of fixed costs in the cost structure.
• Fixed and Variable Costs and Cost Structure.
• Fixed costs don’t change with the level of sales, while
variable costs do
– Fixed costs include rent, depreciation, utilities,
salaries
– Variable costs include direct labor, direct
materials, sales commissions
• The mix of fixed and variable costs in a firm’s operations is
its cost structure

9. The Effect of Operating
Leverage
• As volume moves away from Breakeven(Used t o
det ermine t he level of act ivit y a f irm must
achieve t o st ay in business in t he long run),
profit or loss increases faster with more operating leverage
• The Risk Effect
More operating leverage leads to larger variations in
EBIT, or business risk
• The Effect on Expected EBIT
• Thus, when a firm is operating above breakeven, more
operating leverage implies higher operating profit
 I f a f irm is relat ively sure of it s operat ing
level, it is in t he f irm’s best int erest s t o
t rade variable cost s f or f ixed cost
(assuming t he f irm is operat ing above

10. Breakeven Diagram at High and
Low Operating Leverage

11. The Degree of Operating
Leverage (DOL)—A
Measurement
• Operating leverage amplifies changes in sales volume
into larger changes in EBIT
• DOL relates relative changes in volume (Q) to relative
changes in EBIT.
DOL = %change in EBT %change in Sales
DOL = Sales – Variable Costs EBIT

12. example
A company is perfectly selling 5000 units of a
product @ Rs 20 per unit. If variable cost is Rs 6
per unit & fixed operational cost are Rs 80000.
Find DOL
sol :- sales = 20*5000 = 100000
VC = 30000
contribution = 70000
(-) FC = 80000
EBIT = 10000
therefore, DOL = 70000/10000 = 7%

13. Financial Leverage
• Measure of the amount of debt used by a firm.
• a  in EBIT (or OI) → a larger  in EPS.
• Financial Leverage measures the sensitivity of a firm’s
earnings per share to a  in operating income.
• Used as a means of increasing the return to common
shareholders.
• Financial leverage magnifies changes in EBIT into larger
changes in ROE and EPS
• The degree of financial leverage (DFL) relates relative
changes in EBIT to relative changes in EPS.
• An easier method of calculating DFL is:-
EBIT
DFL =
EBIT - Interest

14. Degree of Financial Leverage
(DFL)
• Degree of Financial Leverage -- The percentage
change in a firm’s earnings per share (EPS) resulting from a
1 percent change in operating profit.
DFLDFL =
Percentage change in
earnings per share (EPS)
Percentage change in
operating profit (EBIT)
% EPS
DFL = or % EPS = DFL % EBIT
% EBIT
∆
∆ × ∆
∆

15. Financial Risk
• Financial Risk ---- The added variability in earnings
per share (EPS) -- plus the risk of possible insolvency --
that is induced by the use of financial leverage.
• Debt increases the probability of cash insolvency over an
all-equity-financed firm.

16. Total Firm Risk

17. The Compounding Effect of
Operating Leverage and
Financial Leverage

18. example
Ques :- a company’s EBIT= 10000 & it has 5%
bonds for Rs 40000 & preference shares =
20000. Calculate DFL
Sol:- EBIT = 10000
(-) Interest = 2000
EBT = 8000
Therefore DFL = 10000/8000 = 1.25

19. Example
Ques :-A co. having a total capital of Rs 10 lacs
with 60% as bonds @10% as equity. The
expected sales of firm = 20000 units @20
per unit, VC = 10 per period, fixed
operational cost = Rs 50000, calcualte DOL,
DFL & DCL
Sol:- Sales = 400000
VC = 200000
Contri = 200000
(-) FC = 50000

20. Example contd....
EBIT = 150000
(-) Int =60000
EBT = 90000
Therefore, DOL = 200000/150000 = 1.33
DFL = 150000/90000 = 1.67
DCl = DFL*DOL = 2.22