This document discusses different types of leverage: 1. Operating leverage refers to how operating profits vary with sales. Higher fixed costs lead to higher operating leverage and risk. 2. Financial leverage refers to using debt financing. Higher debt leads to higher financial leverage and risk but can also increase returns. 3. Composite leverage is the combined effect of operating and financial leverage on overall risk and returns. The document provides examples of calculating operating, financial, and composite leverage.

1. •Leverage is the effect on earnings available to the
shareholders due to the use of fixed cost capital
•Higher is the leverage, higher is the risk and higher is
the expected return

2. Types of leverages
1. Operating leverage
2. Financial leverage
3. Composite leverage

3. 1. Operating leverage
 It is defined as the tendency of the operating profit to vary
disproportionately with sales.
 The firm is said to have high degree of operating leverage if it
employs a greater amount of fixed cost and a small amount of
variable cost.
 On the other hand, a firm will have a low operating leverage
when it employs a greater amount of variable costs and a smaller
amount of fixed cost
 There will be no operating leverage, if there is no fixed operating
costs.
Operating leverage = Contribution
Operating profit
Note: Operating profit means earnings before interest and
tax(EBIT)
 Operating leverage may be favorable or unfavorable. Incase
contribution (ie, sales less variable cost) exceeds fixed cost, there
is favorable operating leverage. In the reverse case, the operating
leverage will be termed as unfavorable.

4. 1. Operating leverage (cont…d)
Degree of operating leverage= % change in profit
% change in sales
 A small drop in sales can be excessively damaging to the
firm’s efforts to achieve profitability, if a firm has a high
degree of operating leverage
 Eg: The installed capacity of a factory is 600 units. Actual
capacity used is 400 units. Selling price per unit is Rs 10.
Variable cost is Rs 6/unit. Calculate the operating leverage
in each of the following three solutions.
a) When fixed cost are Rs 400
b) When fixed cost are Rs 1000
c) When fixed cost are Rs 1200

5. 1. Operating leverage (cont..d)
 Statement showing operating leverage
Situation 1 Situation 2 Situation 3
(i) Sales 4000 4000 4000
(ii) Variable cost 2400 2400 2400
(iii) Contribution (S-V) 1600 1600 1600
(iv) Fixed cost 400 1000 1200
(v) Operating profit(C-F) 1200 600 400
(vi) Operating leverage(C :- OP) 1.33 2.67 4.00
The above example shows that the degree of operating leverage increases with
every increase in share of fixed cost in the total capital structure. In situation 3 it
shows that if sales increases by one rupee, the profit would increase by Rs 4

6. 2. Financial leverage
 The use of fixed source of funds such as debt and preference
capital along with equity capital in the capital structure is
described as financial leverage or gearing or trading on equity
Degree of financial leverage= % change in EPS
% change in EBIT
Eg: A co. has the following capital structure
10000 equity shares of Rs 10 each 100000
2000, 10% preference shares of Rs 100 each 200000
2000, 10% debentures of Rs 100 each 200000
Calculate the EPS for each of the following levels of EBIT(i)Rs
100000 (ii) Rs 60000 (iii) 140000 .The co. is in 50% tax bracket
Calculate the financial leverage taking EBIT level under each
base

7. 2. Financial leverage(cont…d)
 Solution Situation I Situation II Situation III
EBIT 100000 60000 140000
Less Interest 20000 20000 20000
EBT 80000 40000 120000
Less Tax 40000 20000 60000
PAT 40000 20000 60000
Less preference dividend 20000 20000 20000
Earnings available for equity
shareholders
20000 Nil 40000
EPS 2 --- 4
a) In case (ii) if the EBIT has decreased by 40% ((ie, from 100000 to 60000) EPS has
decreased by 1000% (ie, from 2/share to Nil
b) In case (iii) if the EBIT has increased by 40% (from 100000 to 140000) as compared to case
(i) EPS has increased by 100% (from Rs 2 to Rs 4/share)

8. 3. Composite Leverage
Composite leverage= Operating leverage x Financial leverage
 It is the combined effect of operating and financial leverage.