FINANCIAL MANAGEMENT

CHAPTER 8

LEVERAGE ANALYSIS

Learning Objectives
After reading this unit, you will be able to:
Explain the meaning of different leverages
Calculate various leverages
State the effect of these leverages

Structure
8.1 Introduction
8.2 Meaning of Leverage
8.3 Types of Leverage
8.4 Effect of Leverage
8.5 Summary

8.1 Introduction

Management is faced with two problems relating to procurement of capital and

its use in business. Operating leverage deals with use of funds in business and
financial leverage deals with borrowing of funds. This unit deals with borrowing
of funds, use of funds and their combined effect on profitability of the business.

8.2 Meaning Of Leverage

The term leverage refers to relationship between two interrelated variables.

These variables may be Cost, Output, Sales, EBIT, EPS.
Leverage = % change in dependent variable_
% change in independent variable
Example: Firm increase sales promotion expenses from Rs. 5,000 to 6,000
This has resulted in no. of units sold to increase from 200 to 300
Leverage = % change in units sold_______
% change in sales promotion expenses
= 50%
20%
= 2.5
This means if sales promotion expenses increase by 20%, units sold will
increase by 50%.
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8.3 Types Of Leverage

a) Operating Leverage (O.L.)

It is the % change in EBIT as a result of % change in sales
O.L. = % change in EBIT
% change in Sales
Or
= Contribution
EBIT
Or
= Contribution_ ___
Contribution (-) Fixed cost
High O.L. means:
Ø High fixed cost by way of depreciation and other costs
Ø Higher risk to company
Ø EBIT increases faster in response to increase in sales

a) Financial Leverage (F.L.)

It is % change in EPS as a result of % change in EBIT

F.L. = % change in EPS

% change in EBIT
Or
= EBIT
EBT
Or
= E.B.I.T. ( 1 – t )___
(EBIT. – I ) ( 1 – t ) – Dp
Where t = Tax Rate
I = Interest
Dp = Preference Dividend
High F.L. means:
Ÿ Higher level of borrowings and high interest cost
Ÿ Higher risk to company
Ÿ EPS increases faster in response to increase in EBIT

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a) Combined Leverage (C.L.)

It is a % change in EPS as a result of % change in sales
C.L. = O.L. x F.L.
b) Calculating Leverages
Sales
(-) Variable Cost
= Contribution (A)
(-) Fixed Cost
= EBIT (B)
(-) Interest
= EBT (C)
O.L. = A / B
F.L. = B / C
C.L. = O.L. x F.L.

8.4 Effect Of Leverage

O.L. F.L. Comments

High High (I) High fixed cost and high borrowings
(ii) Highest risk
(iii) Expansion on external borrowings
(iv) High interest outflow

High Low (i) High fixed cost and less borrowings

(ii) Risk is reduced due to low borrowings
(iii) Company is expanding but less dependent on external funds
(iv) Low interest outflow

Low High (i) Low fixed cost and high borrowings

(ii) Borrowings are used mainly for variable costs which are in
line with increase in sales
(iii) Risk is further reduced due to low fixed cost
(iv) Ideal situation for profit maximization

Low Low (i) Low fixed cost and low borrowings

(ii) Management is over cautious
(iii) No expansion plans
(iv) Minimum interest outflow
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Illustration 1:
Sales = Rs. 20,000
Variable cost = Rs. 14,000
Fixed cost = Rs. 4,000
What is operating leverage of company. How you will interpret it?
Solution:
Sales = Rs. 20,000
- Variable cost = Rs. 14,000
= Contribution = Rs. 6,000 (a)
- Fixed cost = Rs. 4,000
= E.B.I.T. = Rs. 2,000 (b)
Operating Leverage = a/b
= 6,000
2,000
= 3
Interpretation: If sales of company ↑ 100%, EBIT will ↑ 300%
If sales of company ↓ 100%, EBIT will ↓ 300%
Illustration 2:
Sales Rs. 8,00,000
P/V 20%
Fixed cost Rs. 40,000
Interest Rs. 20,000
Decide: (i) Operating leverage (ii) Financial leverage
(iii) Combined leverage
Give your interpretation.
Solution: Amt. ( Rs. )
Sales 8,00,000
P/V 20%
Contribution 1,60,000 (a) [ P/V = C i.e. sales x P/V
= Contribution ] S
(-) Fixed cost 40,000
= E.B.I.T. 1,20,000 (b)
(-) Interest 20,000
= EBT 1,00,000 (c)
O.L. (a/b) 1.33
F.L. (a/c) 1.20
C.L. = O.L. x F.L. 1.60

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Interpretation:
1. When sales ↑ or ↓ by 100% E.B.I.T. ↑ or ↓ by 133.3%
2. When EBIT ↑ or ↓ by 100% E.P.S. ↑ or ↓ by 120%
3. When sales ↑ or ↓ by 100% E.P.S. ↑ or ↓ by 160%

Illustration 3:
Operating leverage is 2 and financial leverage is 1.5. Interest paid by company
is Rs. 2 lakh and fixed cost is Rs. 3 lakh. Prepare income statement of
company if tax rate is 40% and P/V ratio for company is 30%.

Solution:
F.L.= E.B.I.T.
E.B.T.

= E.B.I.T. __
E.B.I.T. – Interest
1.5 = E.B.I.T.__
E.B.I.T. – 2

1.5 (EBIT) – 3 = E.B.I.T.

1.5 (E.B.I.T.) – E.B.I.T. = 3

0.5 (EBIT) = 3

E.B.I.T. = 3 = 6
0.5
O.L. = __C__
E.B.I.T.

C = O.L. x EBIT
= 2 x 6
= 12
Now C = P/V
S
Hence C = S
P/V
_12_ = 40
30%
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Income Statement Rs. in Lakh.
Sales 40
P/V 30%
= Contribution 12
(-) Fixed Cost 6
= E.B.I.T. 6
(-) Interest 2
= E.B.T. 4
(-) Tax ( 40%) 1.60
= E.A.T. 2.40

Illustration: 4
Net Sales = 10 Crore.
EBIT = 20% of sales
Tax rate = 40%
Equity capital Rs. 2 crore
Preference capital (10%) Rs. 3 crore
Debentures (12%) Rs. 5 crore
Calculate: (a) E.P.S. (b) Percentage change in EPS. If E.B.I.T. increases
by 10% (c) Calculate financial leverage.
Solution:
a) E.P.S. = (E.B.I.T. – Interest) ( 1 – t) – Dp
N
t = Tax rate = 40%
Dp = Preference dividend = 10% of Rs. 3 Crs. = Rs. 0.3 Crs.
Interest = 12% of Rs. 5 Crs. = Rs. 0.6 Cr.
N = No. of equity shares in Crs. = 0.2 Cr.
EBIT = 20% of 10 = 2 Crore
Hence,
a) (E.P.S.)1 = [ 2 – 0.6 ] ( 1-0.4) - 0.3
0.2
= (1.4) (0.6) - 0.3
0.2
= 0.84 - 0.30
0.2
= 0.54
0.2
= Rs. 2.70

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b) (E.P.S.)2 = (New E.B.I.T. - Interest ) ( 1 – t) – Dp

N
New E.B.I.T.= 1.1 x E.B.I.T.
= 1.1 x 2 Cr.
= 2.2 Crs.
(EPS)2 = (2.2 – 0.6) ( 1 – 0.4) – 0.3
0.2
= (1.6) ( 0.6) - 0.3
0.2
= 0.96 - 0.3
0.2
= 0.66
2
= Rs. 3.3
c) F.L. = % Change in E.P.S.
% Change in EBIT.
% Change in E.P.S. = [(EPS)2 - (EPS.)1] x 100
(E.P.S.)1
= [(3.3) - ( 2.70)] x 100
2.70
= 22.22%
Hence F.L. = 22.22%
10%
= 2.22
Illustration 5:
The following figures relate to two companies: [Rs. lakh.]
Particulars P Ltd. Q Ltd.
Sales 500 1,000
Variable costs 200 300
Contribution 300 700
Fixed Cost 150 400
150 300
Interest 50 100
Profit before Tax (PBT) 100 200
You are required to calculate –
(a) Operating financial and combined leverages of the two companies and
(b) Comment on the relative position of the companies in respect of the risk.

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Solution:
[Rs. in lakh]
Particulars P Ltd Q Ltd.
Operating leverage Contribution 300 = 2 700 = 2.33
EBIT 150 300
Financial leverage EBIT 150 = 1.5 300 = 1.5
EBT 100 200
Combined leverage Contribution 300 = 3 700 = 3.5
EBT 100 200
Comment:
Ÿ The operating leverage is higher for Q Ltd. and therefore it is subject to
greater degree of business risk than P Ltd. The EBIT will tend to vary more
with sales in Q Ltd.
Ÿ The financial leverage of both the companies stand at 1.5 times. It conveys
that interest burden is proportionately same and also financial risk is similar
both the companies.
Ÿ The combined leverage of Q Ltd. is higher and its overall risk is more as
compared to P Ltd.
Illustration 6:
A firm has sales of Rs. 75,00,000 variable cost of Rs. 42,00,000 and fixed cost
of Rs. 6,00,000. It has a debt of Rs. 45,00,000 at 9% and equity of Rs.
55,00,000.
i) What is the firm's ROI?
ii) Does it have favorable financial leverage ?
iii) If the firm belongs to an industry whose asset turnover is 3, does it have a
high or low asset leverage?
iv) What are the operating, financial and combined leverages of the firm?
v) If the sales drop to Rs. 50,00,000. What will be the new EBIT ?
vi) At what level the EBT of the firm will be equal to zero?
Solution:
Calculation of EBIT and EBT Rs.
Sales 75,00,000
Less: Variable cost 42,00,000
Contribution 33,00,000
Less: Fixed costs 6,00,000
EBIT 27,00,000
Less: Interest on debt (@ 9% on Rs. 45 lakh.) 4,05,000
EBT 22,95,000

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i) ROI = _EBIT x 100_

Capital employed

= EBIT x 100
Equity + Debt.

= 27,00,000 x 100__
55,00,000 + 45,00,000

= 27%

ii) The return on investment of Firm is 27% where as the firm is only paying 9%
rate of interest on its debt and hence the firm is enjoying favorable financial
leverage.
iii) Asset Turnover = Net Sales
Total Assets

Or = Net sales_
Total Investment

= 75,00,000
1,00,00,000

= 0.75
As compared to the industry's normal asset turnover of 3 times, the firm's asset
turnover ratio is only 0.75 and the investment level of the firm is highly
abnormal.
iv) Calculation of operating, financial and combined leverages

a) Operating Leverage =Contribution =33,00,000 = 1.22

EBIT 27,00,000

b) Financial Leverage =EBIT =27,00,000 = 1.18

EBT 22,95,000

c) Combined Leverage =Contribution =33,00,000 = 1.44

EBT = 22.95,000
Or = Operating Leverage x Financial Leverage = 1.22 x 1.18= 1.44

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v) New EBIT when sales drop to Rs. 50,00,000 Rs.
New Sales (After 33.33% drop) 50,00,000
Less: Variable cost (Rs. 42 lakh 33.33%) 28,00,000
Contribution 22,00,000
Less: Fixed Cost 6,00,000
New EBIT 16,00,000
vi) Sales level at which EBT of the firm will be equal to zero. Since the
combined leverage is 1.44, sales have to drop by 100 / 1.44 i.e. 69.44%
New sales = 75,00,000 x (1 – 0.6944)
= Rs. 22,92,000 (approx)

New Sales (After 33.33% drop) 50,00,000

Less: Variable cost (Rs. 42 lakh 33.33%) 28,00,000
Contribution 22,00,000
Less: Fixed Cost 6,00,000
New EBIT 16,00,000
vi) Sales level at which EBT of the firm will be equal to zero. Since the
combined leverage is 1.44, sales have to drop by 100 / 1.44 i.e. 69.44%
New sales = 75,00,000 x (1 – 0.6944)
= Rs. 22,92,000 (approx)
Illustration 7:
The following financial data have been furnished by A Ltd. and B Ltd. for the
year ended31-3-2016.

Particulars A Ltd. B Ltd.

Operating leverage 3:1 4:1
Financial leverage 2:1 3:1
Interest charges per annum Rs. 12 lakh Rs. 10 lakh
Corporate tax rate 40% 40%
Variable cost as % of sales 60% 50%

Prepare Income statement of the two companies. Also comment on the

financial position and structure of the two companies.

Solution:
A Ltd. data
a) Calculation of EBIT
Financial leverage (given) = 2

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EBIT ___ = 2
EBIT - Interest

EBIT = 2
EBIT - 12
2 EBIT - 24 = EBIT

EBIT = Rs. 24 lakh

b) Calculation of Contribution
Operating leverage (given) = 3

Contribution = 3
EBIT

Contribution = 3
24
Contribution = Rs. 72 lakh

c) Calculation of Fixed Cost

Operating leverage (given) = 3

Contribution = 3
Contribution – FC

___72 = 3
72 - FC

(3 x 72) - 3 FC = 72

3 FC = 216 - 72

FC = 144/3

Fixed cost = Rs. 48 lakh

d) Calculation of sales
Contribution = 40%
Sales

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Sales = 72 x 100 / 40

= Rs. 180 lakh

Similarly, following the above procedure, the basic data of B Ltd. can also be
ascertained.
Particulars A Ltd. B Ltd.
Operating leverage (Contribution / EBIT) 3 4
Financial leverage ( EBIT / EBT) 2 3
Combined leverage (Contribution / EBT) 6 12
P.V. Ratio (Contribution / Sales) 40% 50%

Comments:
Ÿ Contribution / Sales ratio is more in case of B Ltd.
Ÿ Operating leverage of B Ltd. is more than that of A Ltd. indicating a
larger proportion of fixed costs in the former. The ratio of fixed costs to
sales is 37.5% for B Ltd. against 26.67% for A Ltd.
Ÿ Finance leverage for B Ltd. is 3 against 2 for A Ltd. This indicates a
higher percentage of debt in the capital structure of B Ltd. although in
absolute terms the interest amount is less. Interest accounts for 81/3%
of sales realization is B Ltd. as against 62/3% only for A Ltd.
Ÿ Although contribution / sales is more for B Ltd., both operating leverage
and financial leverage are higher for the company. As a result
profitability (EAT/sales) is only 2.5% as against 4% for A Ltd.

Illustration 8:
The balance sheet of Alpha Numeric Company is given below:
Liabilities Rs. Assets Rs.
Equity capital (Rs. 10 per share) 90,000 Net fixed assets 2,25,000
10% Long-term debt 1,20,000 Current Assets 75,000
Retained earnings 30,000 Current liabilities 60,000

3,00,000 3,00,000

The Company's total assets turnover ratio is 3, its fixed operating costs is
Rs. 1,50,000 and its variable operating cost ratio is 50%. The income – tax
rate is 50%.
You are required to
(i) Calculate the different type of leverages for the company.
(ii) Determine the likely level of EBIT if EPS is:

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(a) Re. 1 (b) Rs. 2 (c) Rs. 0

Solution:
___Sales _ = Sales Turnover Ratio
Total Assets

__Sales__ = 3
3,00,000
Sales = 3 x 3,00,000

= Rs. 9,00,000
i) Calculation of Leverage
Income statement for the year ended Rs.
Sales 9,00,000
Less: Variable cost (50% of sales) 4,50,000
Contribution 4,50,000
Less: Fixed operating cost 1,50,000
EBIT 3,00,000
Less: Interest (Rs. 1,20,000 x 10 / 100) 12,000
EBT 2,88,000
Less: Tax (@ 50%) 1,44,000
EAT 1,44,000
a) Operating leverage = Contribution
EBIT

= 4,50,000 = 1.50
3,00,000

b) Financial Leverage = EBIT

EBT

= 3,00,000 = 1.04
2,88,000
c) Combined leverage = Operating leverage x Financial
leverage
= 1.50 x 1.04 =1.56

i) Calculation of likely levels of EBIT at different level of EPS

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EPS = (EBIT - I ) ( 1 – t )
N

a) Level of EBIT, if EPS is Re. 1

1 = (EBIT – 12,000) ( 1 – 0.50)
9,000

9,000 = (EBIT - 12,000) ( 0.50)

9,000 = 0.50 EBIT - 6,000

0.50 EBIT = 9,000 + 6,000
EBIT = 15,000
0.50
= Rs. 30,000
b) Level of EBIT, If EPS is Rs. 2
2 = (EBIT - 12,000) ( 1 – 0.50)
9,000

9,000 x 2 = (EBIT - 12,000) ( 0.50)

18,000 = 0.50 EBIT - 6,000

0.50 EBIT = 18,000 + 6,000

EBIT = 24,000 / 0.50

= Rs. 48,000

c) Level of EBIT, if EPS is Re. 0

0 =(EBIT – 12,000) ( 1 – 0.50)
9,000

9,000 x 0 = (EBIT – 12,000) ( 0.50)

0.50 EBIT- 6,000 = 0

0.50 EBIT = 6,000

EBIT = 6,000 / 0.50

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Illustration 9:
You are a finance manager in Big Pen Ltd. The degree of operating
leverage of your company is 5.0. The degree of financial of your company is
3.0. Your Managing Director has found that the degree of operating
leverage and the degree of financial leverage of your nearest competitor
Small Pen Ltd. are 6.0 and 4.0 respectively. In his opinion, the Small pen
Ltd. is better than of Big Pen Ltd. because of higher value of degree of
leverages. Do you agree with the opinion of your Managing Director? Give
reasons.

Solution:
Particulars Big Pen Ltd. Small Pen Ltd.
1) Operating leverage = Contribution 5 6
EBIT

2) Financial Leverage = EBIT 3 4

EBT

3) Combined leverage = Contribution 15 24

EBT

Ÿ The operating leverage of Big Pen Ltd. is 5 and of small Pen Ltd. is 6.
It means change in the level of sales will have more impact on EBIT of
small Pen Ltd. than that of Big Pen Ltd. The volume of fixed cost may
be higher in case of small Pen Ltd. than that of Big Pen Ltd. The
business risk of small Pen Ltd. is also more as compared to Big. Pen
Ltd.

Ÿ The financial leverage of Big Pen Ltd. is 3 and of small Pen Ltd. is 4. It
means that the interest burden of small Pen Ltd. is higher than Big
Pen Ltd. Financial risk of small Pen Ltd. is higher as compared to Big
Pen Ltd.

Ÿ The degree of combined leverage of Big Pen Ltd. is 15 and that of

small Pen Ltd. is 24 It means any change in sales will show more
impact on EPS in case of small Pen Ltd.

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Illustration 10:
From the following information available for four companies, calculate –
(a) EBIT
(b) EPS
(c) Operating leverage
(d) Financial leverage

Particulars P Q R S

Selling price / unit (Rs.) 15 20 25 30

Variable cost/unit (Rs.) 10 15 20 25
Quantity (Nos.) 20,000 25,000 30,000 40,000
Fixed Costs (Rs.) 30,000 40,000 50,000 60,000
Interest (Rs.) 15,000 25,000 35,000 40,000
Tax rate (%)40 40 40 40
No. of equity shares 5,000 9,000 10,000 12,000

Solution:
Company P Q R S

Selling price / unit (Rs.) [a] 15 20 25 30

Variable cost / unit (Rs.) [b] 10 15 20 25
= Contribution / unit (Rs.) [c] 5 5 5 5

Quantity (Nos.)[d] 20,000 25,000 35,000 40,000

Total Contribution (cxd) [e] 1,00,000 1,25,000 1,75,000 2,00,000
Fixed Cost (Rs.) [f] 30,000 40,000 50,000 60,000

= E.B.I.T. (Rs.) [g] 70,000 85,000 1,25,000 1,40,000

- Interest (Rs.) [h] 15,000 25,000 35,000 40,000

= E.B.T. (Rs.) [ i] 60,000 6,000 90,000 1,00,000

- Tax (40%) (Rs.) [j] 24,000 24,000 36,000 40,000

= E.A.T. (Rs.) [k] 36,000 36,000 54,000 60,000

No. of Equity shares [l] 5,000 9,000 10,000 12,000

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Operating leverage [e/g] 1.43 1.47 1.40 1.43

Financial Leverage [ g/I] 1.17 1.42 1.39 1.40
E.P.S. [k/l] 7.20 4.0 5.40 5.00

8.5 Summary

Ÿ Leverage refers to ability of business to borrow and employ long-term

funds to increase returns to owners.
Ÿ Operating leverage indicates extent to which fixed costs have been
incurred by company . Higher operating leverage means higher level of fi
xed costs
Ÿ Financial leverage indicates borrowing of company. High financial
leverage means high borrowings.
Ÿ Combined leverage indicates combined effect of above two leverages.

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