MBA (FT) 2nd Semester (2024-26)

I. What is Leverage?
In finance, leverage is a strategy that companies use to increase assets, cash flows, and returns,
though it can also magnify losses. There are two main types of leverage: financial and
operating. To increase financial leverage, a firm may borrow capital through issuing fixed-
income securities or by borrowing money directly from a lender.
The word ‘leverage’, borrowed from physics, is frequently used in financial management.
The object of application of which is made to gain higher financial benefits compared to the
fixed charges payable, as it happens in physics i.e., gaining larger benefits by using lesser
amount of force.
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In short, the term ‘leverage’ is used to describe the ability of a firm to use fixed cost assets or
funds to increase the return to its equity shareholders. In other words, leverage is the
employment of fixed assets or funds for which a firm has to meet fixed costs or fixed rate of
interest obligation—irrespective of the level of activities attained, or the level of operating
profit earned.
Leverage occurs in varying degrees. The higher the degree of leverage, the higher is the risk
involved in meeting fixed payment obligations i.e., operating fixed costs and cost of debt
capital. But, at the same time, higher risk profile increases the possibility of higher rate of return
to the shareholders.
Some definitions are given to have a clear idea about leverage:
According to Ezra Solomon:
“Leverage is the ratio of net returns on shareholders equity and the net rate of return on
capitalisation”.
According to J. C. Van Home:
“Leverage is the employment of an asset or funds for which the firm pays a fixed cost of fixed
return.”
Types of Leverage:
Leverage are the three types:
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(i) Operating leverage
(ii) Financial leverage and
(iii) Combined leverage
1. Operating Leverage:
Operating leverage refers to the use of fixed operating costs such as depreciation, insurance of
assets, repairs and maintenance, property taxes etc. in the operations of a firm. But it does not
include interest on debt capital. Higher the proportion of fixed operating cost as compared to
variable cost, higher is the operating leverage, and vice versa.
Operating leverage may be defined as the “firm’s ability to use fixed operating cost to magnify
effects of changes in sales on its earnings before interest and taxes.”
In practice, a firm will have three types of cost viz:
(i) Variable cost that tends to vary in direct proportion to the change in the volume of activity,
(ii) Fixed costs which tend to remain fixed irrespective of variations in the volume of activity
within a relevant range and during a defined period of time,
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(iii) Semi-variable or Semi-fixed costs which are partly fixed and partly variable. They can be
segregated into variable and fixed elements and included in the respective group of costs.
Operating leverage occurs when a firm incurs fixed costs which are to be recovered out of sales
revenue irrespective of the volume of business in a period. In a firm having fixed costs in the
total cost structure, a given change in sales will result in a disproportionate change in the
operating profit or EBIT of the firm.
If there is no fixed cost in the total cost structure, then the firm will not have an operating
leverage. In that case, the operating profit or EBIT varies in direct proportion to the changes in
sales volume.
Operating leverage is associated with operating risk or business risk. The higher the fixed
operating costs, the higher the firm’s operating leverage and its operating risk. Operating risk
is the degree of uncertainty that the firm has faced in meeting its fixed operating cost where
there is variability of EBIT.
It arises when there is volatility in earnings of a firm due to changes in demand, supply,
economic environment, business conditions etc. The larger the magnitude of operating
leverage, the larger is the volume of sales required to cover all fixed costs.
Illustration 1:
A firm sells its product for Rs. 5 per unit, has variable operating cost of Rs. 3 per unit and fixed
operating costs of Rs. 10,000 per year. Its current level of sales is 20,000 units. What will be
the impact on profit if (a) Sales increase by 25% and (b) decrease by 25%?
Solution

(a) A 25% increase in sales (from 20,000 units to 25,000 units) results in a 33 1/3% increase in
EBIT (from Rs. 30,000 to Rs. 40,000).
(b) A 25% decrease in sales (from 20,000 units to 15,000 units) results in a 33 1/3% decrease
in EBIT (from Rs. 30,000 to Rs. 20,000).
The above illustration clearly shows that when a firm has fixed operating costs an increase in
sales volume results in a more than proportionate increase in EBIT. Similarly, a decrease in the
level of sales has an exactly opposite effect. The former operating leverage is known as
favourable leverage, while the latter is known as unfavorable.
Degree of Operating Leverage:
The earnings before interest and taxes (i.e., EBIT) changes with increase or decrease in the
sales volume. Operating leverage is used to measure the effect of variation in sales volume on
the level of EBIT.
The formula used to compute operating leverage is:
A high degree of operating leverage is welcome when sales are rising i.e., favourable market
conditions, and it is undesirable when sales are falling. Because, higher degree of operating
leverage means a relatively high operating fixed cost for recovering which a larger volume of
sales is required.
The degree of operating leverage is also obtained by using the following formula:
Degree of operating leverage (DOL) = Percentage change in EBIT / Percentage Change in
Units Sold
The value of degree of operating leverage must be greater than 1. If the value is equal to 1 then
there is no operating leverage.
Importance of Operating Leverage:
1. It gives an idea about the impact of changes in sales on the operating income of the firm.
2. High degree of operating leverage magnifies the effect on EBIT for a small change in the
sales volume.
3. High degree of operating leverage indicates increase in operating profit or EBIT.
4. High operating leverage results from the existence of a higher amount of fixed costs in the
total cost structure of a firm which makes the margin of safety low.
5. High operating leverage indicates higher amount of sales required to reach break-even point.
6. Higher fixed operating cost in the total cost structure of a firm promotes higher operating
leverage and its operating risk.
7. A lower operating leverage gives enough cushion to the firm by providing a high margin of
safety against variation in sales.
8. Proper analysis of operating leverage of a firm is useful to the finance manager.
2. Financial Leverage:
Financial leverage is primarily concerned with the financial activities which involve raising of
funds from the sources for which a firm has to bear fixed charges such as interest expenses,
loan fees etc. These sources include long-term debt (i.e., debentures, bonds etc.) and preference
share capital.
Long term debt capital carries a contractual fixed rate of interest and its payment is obligatory
irrespective of the fact whether the firm earns a profit or not.
As debt providers have prior claim on income and assets of a firm over equity shareholders,
their rate of interest is generally lower than the expected return in equity shareholders. Further,
interest on debt capital is a tax deductible expense.
These two facts lead to the magnification of the rate of return on equity share capital and hence
earnings per share. Thus, the effect of changes in operating profits or EBIT on the earnings per
share is shown by the financial leverage.
According to Gitman financial leverage is “the ability of a firm to use fixed financial charges
to magnify the effects of changes in EBIT on firm’s earnings per share”. In other words,
financial leverage involves the use of funds obtained at a fixed cost in the hope of increasing
the return to the equity shareholders.
Favourable or positive financial leverage occurs when a firm earns more on the assets/
investment purchased with the funds, than the fixed cost of their use. Unfavorable or negative
leverage occurs when the firm does not earn as much as the funds cost.
Thus shareholders gain where the firm earns a higher rate of return and pays a lower rate of
return to the supplier of long-term funds. The difference between the earnings from the assets
and the fixed cost on the use of funds goes to the equity shareholders. Financial leverage is
also, therefore, called as ‘trading on equity’.
Financial leverage is associated with financial risk. Financial risk refers to risk of the firm not
being able to cover its fixed financial costs due to variation in EBIT. With the increase in
financial charges, the firm is also required to raise the level of EBIT necessary to meet financial
charges. If the firm cannot cover these financial payments it can be technically forced into
liquidation.
Illustration 2:
One-up Ltd. has Equity Share Capital of Rs. 5,00,000 divided into shares of Rs. 100 each. It
wishes to raise further Rs. 3,00,000 for expansion-cum-modernisation scheme.
The company plans the following financing alternatives:
(i) By issuing Equity Shares only.
(ii) Rs. 1,00,000 by issuing Equity Shares and Rs. 2,00,000 through Debentures @ 10% per
annum.
(iii) By issuing Debentures only at 10% per annum.
(iv) Rs. 1,00,000 by issuing Equity Shares and Rs. 2,00,000 by issuing 8% Preference Shares.
You are required to suggest the best alternative giving your comment assuming that the
estimated earnings before interest and taxes (EBIT) after expansion is Rs. 1,50,000 and
corporate rate of tax is 35%.
In the above example, we have taken operating profit (EBIT = Rs. 1,50,000) constant for
alternative financing plans. It shows that earnings per share (EPS) increases with the increase
in the proportion of debt capital (debenture) to total capital employed by the firm, the firm’s
EBIT level taken as constant.
Financing Plan I does not use debt capital and, hence, Earning per share is low. Financing Plan
III, which involves 62.5% ordinary shares and 37.5% debenture, is the most favourable with
respect to EPS (Rs. 15.60). The difference in Financing Plans II and IV is due to the fact that
the interest on debt is tax-deductible while the dividend on preference shares is not.
Hence, financing alternative III should be accepted as the most profitable mix of debt and
equity by One-up Ltd. Company.
Degree of Financing Leverage:
Financing leverage is a measure of changes in operating profit or EBIT on the levels of earning
per share.
It is computed as:
Financial leverage = Percentage change in EPS / Percentage change in EBIT = Increase in EPS
/ EPS / Increase in EBIT/EBIT
The financial leverage at any level of EBIT is called its degree. It is computed as ratio of EBIT
to the profit before tax (EBT).
Degree of Financial leverage (DFL) = EBIT / EBT
The value of degree of financial leverage must be greater than 1. If the value of degree of
financial leverage is 1, then there will be no financial leverage. The higher the proportion of
debt capital to the total capital employed by a firm, the higher is the degree of financial leverage
and vice versa.
Again, the higher the degree of financial leverage, the greater is the financial risk associated,
and vice versa. Under favourable market conditions (when EBIT may increase) a firm having
high degree of financial leverage will be in a better position to increase the return on equity or
earning per share.
Importance of Financial Leverage:
The financial leverage shows the effect of changes in EBIT on the earnings per share. So it
plays a vital role in financing decision of a firm with the objective of maximising the owner’s
wealth.
The importance of financial leverage:
1. It helps the financial manager to design an optimum capital structure. The optimum capital
structure implies that combination of debt and equity at which overall cost of capital is
minimum and value of the firm is maximum.
2. It increases earning per share (EPS) as well as financial risk.
3. A high financial leverage indicates existence of high financial fixed costs and high financial
risk.
4. It helps to bring balance between financial risk and return in the capital structure.
5. It shows the excess on return on investment over the fixed cost on the use of the funds.
6. It is an important tool in the hands of the finance manager while determining the amount of
debt in the capital structure of the firm.
3. Combined Leverage:
Operating leverage shows the operating risk and is measured by the percentage change in EBIT
due to percentage change in sales. The financial leverage shows the financial risk and is
measured by the percentage change in EPS due to percentage change in EBIT.
Both operating and financial leverages are closely concerned with ascertaining the firm’s
ability to cover fixed costs or fixed rate of interest obligation, if we combine them, the result is
total leverage and the risk associated with combined leverage is known as total risk. It measures
the effect of a percentage change in sales on percentage change in EPS.
Degree of Combined Leverage:
The combined leverage can be measured with the help of the following formula:
Combined Leverage = Operating leverage x Financial leverage
The combined leverage may be favourable or unfavorable. It will be favourable if sales increase
and unfavorable when sales decrease. This is because changes in sales will result in more than
proportional returns in the form of EPS. As a general rule, a firm having a high degree of
operating leverage should have low financial leverage by preferring equity financing, and vice
versa by preferring debt financing.
If a firm has both the leverages at a high level, it will be very risky proposition. Therefore, if a
firm has a high degree of operating leverage the financial leverage should be kept low as proper
balancing between the two leverages is essential in order to keep the risk profile within a
reasonable limit and maximum return to shareholders.
Importance of Combined Leverage:
The importance of combined leverage are:
It indicates the effect that changes in sales will have on EPS.
2. It shows the combined effect of operating leverage and financial leverage.
3. A combination of high operating leverage and a high financial leverage is very risky situation
because the combined effect of the two leverages is a multiple of these two leverages.
4. A combination of high operating leverage and a low financial leverage indicates that the
management should be careful as the high risk involved in the former is balanced by the later.
5. A combination of low operating leverage and a high financial leverage gives a better situation
for maximising return and minimising risk factor, because keeping the operating leverage at
low rate full advantage of debt financing can be taken to maximise return. In this situation the
firm reaches its BEP at a low level of sales with minimum business risk.
6. A combination of low operating leverage and low financial leverage indicates that the firm
losses profitable opportunities.

Importance of Leverage in Financial Management

Leverage refers to the use of fixed costs in an attempt to increase profitability. Leverage affects
the level and variability of the firm’s after-tax earnings and hence, the firm’s overall risk and
return. The following are the importance of leverage in financial management:

Measurement of Operating Risk

Operating risk refers to the risk of the firm not being able to cover its fixed operating costs.
Since operating leverage depends on fixed operating costs, larger fixed operating costs indicate
a higher degree of operating leverage and thus, a higher operating risk for the firm. High
operating leverage is good when sales are rising but bad when they are falling.
Measurement of Financial Risk
Financial risk refers to the risk of the firm not being able to cover its fixed financial costs. Since
financial leverage depends on fixed financial costs, high fixed financial costs indicate a higher
degree of operating leverage and thus, high financial risk. High financial leverage is good when
operating profit is rising and bad when it is falling.
Managing Risk
The relationship between operating leverage and financial leverage is multiplicative rather than
additive. Operating leverage and financial leverage can be combined in a number of different
ways to obtain a desirable degree of total leverage and level of total firm risk.
Designing Appropriate Capital Structure Mix
To design an appropriate capital structure mix or financial plan, the amount of EBIT under
various financial plans should be related to earnings per share. It is one widely used means of
examining the effect of leverage to analyze the relationship between EBIT and earnings per
share.
Increased Profitability
Leverage is an effort or attempt by which a firm tries to show high results or more benefits by
using fixed costs assets and fixed return sources of capital. It ensures maximum utilization of
capital and fixed assets in order to increase the profitability of a firm. It helps to know the
reasons for not having more profit by a company.

II. Introduction to Debt Service Coverage Ratio (Use below

link):
https://fastercapital.com/content/Debt-service-coverage-ratio--Analyzing-Cash-Flow-s-
Ability-to-Service-Debt.html