Leverage refers to the use of fixed costs by a firm to magnify the effects of changes in sales on profits. There are three types of leverage: 1) Operating leverage measures how changes in sales affect operating income (EBIT) due to fixed operating costs. A high degree of operating leverage means small sales changes have large effects on profits. 2) Financial leverage measures how changes in operating income (EBIT) affect earnings per share (EPS) due to fixed financing costs. A high degree of financial leverage means small profit changes significantly impact EPS. 3) Combined leverage considers how operating and financial leverage together magnify the effects of sales changes on EPS. The degree of combined leverage is the

1. CHIMC Presented By: Akhilesh Chawda LEVERAGE

2. What is Leverage?

5. TYPES OF LEVERAGE Operating Leverage- Affects a firm’s Business Risk. Financial Leverage-Affects a firm’s Financial Risk Combined Leverage.

6. The variability or uncertainty of a firm’s operating income (EBIT). Affected by: Affected By: Sales volume variability, Competition, Cost variability, Product diversification, Product demand Operating Leverage. Business Risk

7. EBIT Operating Leverage

8. The variability or uncertainty of a firm’s earnings per share (EPS) and the increased probability of insolvency that arises when a firm uses financial leverage Financial Risk

9. EPS Financial Leverage

10. Indifference Point Quantity { Total Revenue Total Cost = Fixed FC Break- even point } Q 1 + - EBIT

11. With high Operating leverage, an increase in sales produces a relatively larger increase in operating income.

12. Sales - variable costs - fixed costs operating income - interest EBT - taxes Net Income } contribution margin EBT (1 - t) = Net Income, so, Net Income / (1 - t) = EBT Analytical Income Statement

13. Operating Leverage : By using fixed operating costs, a small change in sales revenue is magnified into a larger change in operating income. This “multiplier effect” is called the degree of Operating Leverage. Degree of Operating Leverage (DOL)

14. DOLs = % change in EBIT % change in sales change in EBIT EBIT change in sales sales = Degree of Operating Leverage from Sales Level (S)

15. If DOL=2, then a 1% 1% increase in sales will result 2% in a increase in operating income (EBIT). What does this tell us? Stock- holders EBIT EPS Sales

16. Financial Leverage: By using fixed cost financing, a small change in operating income is magnified into a larger change in earnings per share. This “multiplier effect” is called the degree of Financial Leverage. Degree of Financial Leverage (DFL)

17. DFL = % change in EPS % change in EBIT change in EPS EPS change in EBIT EBIT = Degree of Financial Leverage

18. If DFL=3, then a 1% increase in operating income will result in a 3% increase in earnings per share. What does this tell us? Stock- holders EBIT EPS Sales

19. Combined Leverage: By using operating leverage and financial leverage , a small change in sales is magnified into a larger change in earnings per share. This “multiplier effect” is called degree of Combined Leverage. Degree of Combined Leverage (DCL)

20. DCL = DOL x DFL % change in EPS % change in Sales = change in EPS EPS change in Sales Sales = Degree of Combined Leverage

21. Leverage Sales EBIT EPS DOL DFL DCL

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