The document discusses leverage in financial management, focusing on how debt financing affects a firm's profitability through fixed costs. It explains operating, financial, and combined leverage, detailing how changes in sales can significantly impact profits due to fixed costs. Formulas for calculating the degrees of leverage are provided, illustrating the relationships between sales, profits, and costs.

1. LEVERAGE
ANALYSIS
FINANCIAL MANAGEMENT

2. INTRODUCTION
• Leverage refer to the amount of debt a firm uses to finance
assets
• It arises from the existence of fixed costs
• It is an investment strategy to use borrowed money
• If a business is leveraged , it means that the firm has
borrowed money to finance the purchase of assets

3. CONTINUED
• With larger presence of fixed cost profit margins can really
get squeezed when the business scenario is not favorable
and the sales fall. This adds risk to the stocks of such
companies
• Conversely, with the same larger presence of fixed cost
company would experience magnified profits with increase
in sales as the cost level remaining constant

4. MAGNIFICATION EFFECT WITH THE
PRESENCE OF FIXED COST
Case 1 Case2 Case 3
Revenue 15 lacs 21 lacs 12 lacs
- Fixed Cost -10 lacs -10 lacs -10 lacs
= Profit =5 lacs =11 lacs =2 lacs
% Change in Revenue =
Case2 (21-15)/15 * 100 = 40% Case3 (12-15)/15*100 = -20%
% Change in Profit =
Case2 (11-5)/5 * 100 = 120% Case3 (2-5)/5* 100 = -60%

5. TYPES OF LEVERAGE
1. Operating Leverage- It arises with the presence of firm’s fixed
operating costs such as salaries, rent, depreciation, utility expense
etc.
2. Financial Leverage- It arises with the presence of firm’s fixed
financing costs such as interest expenses on debt and preference
shares
3. Combined Leverage- Product of operating and financial leverage

6. FORMULAS
Sales – Variable cost = Contribution
Contribution – Fixed cost = Earning before interest and tax
Earning before Interest and tax – Interest = Earning before Tax
Earning before tax – Tax = Earning after Tax
Earning per share = Earning after Tax / No. of Shares

7. FORMULA
• Degree of Operating Leverage = Contribution / EBIT
• Degree of Operating Leverage = % change in EBIT/ % change in sales
• Degree of Financial Leverage = EBIT/ EBT
• Degree of Financial Leverage = % change in EPS / % change in EBIT
• Degree of Combined Leverage = OL * FL
• Degree of Combined Leverage = % change in EPS / % change in Sales

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