Business Finance Assignment
Business Finance Assignment
AND
OPERATING
LEVERAGES
Principles of Business
Finance
Prepared by:
Name: Abdul Rehman
Roll No: 2K21/BBAE/6
Assignment by: Dr. Maria Sheikh
Contents
Meaning of Leverage .......................................................................................................................................... 3
Degree of Operating Leverage (DOL) ............................................................................................................... 3
Break-Even Analysis and Operating Leverage................................................................................................... 4
Margin of Safety and Operating Leverage ......................................................................................................... 5
Degree of Financial Leverage (DFL) ............................................................................................................... 10
Financial Leverage as ‘Trading on Equity’ ...................................................................................................... 12
Financial Leverage as a ‘Double edged Sword’ ........................................................................................... 13
OPERATING AND FINANCIAL LEVERAGE
Meaning of Leverage
The term leverage represents influence or power. In financial analysis leverage, represents the influence of one
financial variable over some other related financial Variable. These financial variables may be costs, output,
sales revenue, Earnings Before Interest and Tax (EBIT), Earning per share (EPS) etc. Generally, if we want to
Calculate impact of change in variable X on variable Y, it is termed as Leverage of Y With X, and it is
calculated as follows:
Types of Leverage
There are three commonly used measures of leverage in financial analysis. These are:
(i) Operating Leverage: It is the relationship between Sales and EBIT and indicates Business risk.
(ii) Financial Leverage: it is the relationship between EBIT and EPS and indicates Financial risk.
OPERATING LEVERAGE
Operating Leverage means tendency of operating income (EBIT) to change disproportionately with change in
sale volume. This disproportionate change is Caused by operating fixed cost, which does not change with
change in sales volume. In other words, operating leverage (OL) maybe defined as the employment of an Asset
with a fixed cost so that enough revenue can be generated to cover all the
Fixed and variable costs.
The use of assets for which a company pays a fixed cost is called operating leverage. Operating leverage is a
function of three factors:
Mathematically:
Break-even analysis is a generally used to study the Cost Volume Profit analysis. It Is concerned with
computing the break-even point. At this point of production level And sales there will be no profit and loss i.e.
total cost is equal to total sales revenue.
SELLING PRICE
20
40
VARIABLE COST 12
20
CONTRIBUTION 8
20
TOTAL CONTRIBUTION OF
8,000
1000 UNITS 20,000
BREAK-EVEN POINT
(FIXED 15,000/20=750 units 5000/8=625 units
COST/CONTRIBUTION)
OPERATING LEVERAGE
8000/3000=2.67
( CONTRIBUTION/EBIT) 20,000/5,000=4
There is a relationship between leverage and Break-even point. Both are used for Profit planning. In brief the
relationship between leverage, break-even point and Fixed cost as under:
In cost accounting, one studies that margin of safety (MOS) may be calculated as Follows:
Higher margin of safety indicates lower business risk and higher profit and vice Versa. If we both multiply and
divide above formula with profit volume (PV) ratio Then:
We know that:
We know that:
DOL=Contribution ÷ EBIT
Hence:
When Sales is much higher than BEP sales, DOL will be slightly more than one. With Decrease in sales DOL
will increase. At BEP, DOL will be infinite. When sales is Slightly less than BEP, DOL will be negative infinite.
With further reduction in sale, DOL will move towards zero. At zero sales, DOL will also be zero.
A Company produces and sells 10,000 shirts. The selling price per shirt is Rs.500. Variable cost is Rs.200 per
shirt and fixed operating cost is Rs.25,00,000.
I) CALCULATE operating leverage.
II) If sales are up by 10%, then COMPUTE the impact on EBIT?
Solution:
Operating Leverage= Contribution ÷ EBIT = 30 lakhs Operating Leverage ÷ EBIT 5 lakhs = 6 times
6 = X / 5,00,000÷5,00,000 / 50,00,000
X = Rs.3,00,000
Financial Leverage (FL) = Earnings before interest and tax(EBIT)/Earnings before tax(EBT)
Degree of financial leverage is the ratio of the percentage increase in earnings per Share (EPS) to the
percentage increase in earnings before interest and taxes (EBIT). Financial Leverage (FL) is also defined as
“the ability of a firm to use fixed Financial charges to magnify the effect of changes in EBIT on EPS.”
Here
T = Tax Rate
D = Dividend on Preference Shares (inclusive of dividend tax if any)
When DFL is more than one (1), financial leverage exists. More is DFL higher is
financial leverage.
A positive DFL/ FL means firm is operating at a level higher than break-even point
and EBIT and EPS moves in the same direction. Negative DFL/ FL indicates the firm
is operating at lower than break-even point and EPS is negative.
Degree of Finance Leverage – (DFL) = Change in EP/Change in EBIT = 50%/50% = 1
Degree of Finance Leverage – (DFL)= Change in EPS 62.5%/Change in EBIT 50% = 1.25
Financial leverage indicates the use of funds with fixed cost like long term debts And preference share capital
along with equity share capital which is known as Trading on equity. The basic aim of financial leverage is to
increase the earnings Available to equity shareholders using fixed cost fund. A firm is known to have a Positive
leverage when its earnings are more than the cost of debt. If earnings is Equal to or less than cost of debt, it will
be an unfavorable leverage. When the quantity of fixed cost fund is relatively high in comparison to equity
capital it is said that the firm is “trading on equity”.
Financial Leverage as a ‘Double edged Sword’
On one hand when cost of ‘fixed cost fund’ is less than the return on investment Financial leverage will help to
increase return on equity and EPS. The firm will also Benefit from the saving of tax on interest on debts etc.
However, when cost of debt Will be more than the return it will affect return of equity and EPS unfavorably and
As a result firm can be under financial distress. This is why financial leverage is Known as “double edged
sword”.
Note: DFL can never be between zero and one. It can be zero or less or it can be One or more.
Financial BEP is the level of EBIT at which earning per share is zero. If a company Has not issued preference
shares then Financial BEP is simply equal to amount of Interest.
When EBIT is much higher than Financial BEP, DFL will be slightly more than one. With decrease in EBIT,
DFL will increase. At Financial BEP, DFL will be infinite. When EBIT is slightly less than Financial BEP, DFL
will be negative infinite. With further Reduction in EBIT, DFL will move towards zero. At zero EBIT, DFL will
also be zero.