INTRODUCTION

Financial decision is one of the integral and important parts of financial management in
any kind of business concern. A sound financial decision must consider the board coverage
of the financial mix (Capital Structure), total amount of capital (capitalization) and cost of
capital (Ko). Capital structure is one of the significant things for the management, since it
influences the debt equity mix of the business concern, which affects the shareholder’s
return and risk. Hence, deciding the debt-equity mix plays a major role in the part of the
value of the company and market value of the shares. The debt equity mix of the company
can be examined with the help of leverage.
The concept of leverage is discussed in this part. Types and effects of leverage is discussed
in the part of EBIT and EPS.
Meaning of Leverage
The term leverage refers to an increased means of accomplishing some purpose. Leverage
is used to lifting heavy objects, which may not be otherwise possible. In the financial point
of view, leverage refers to furnish the ability to use fixed cost assets or funds to increase
the return to its shareholders.

Definition of Leverage
James Horne has defined leverage as, “the employment of an asset or fund for which the
firm pays a fixed cost or fixed return.

Types of Leverage
Leverage can be classified into three major headings according to the nature of the finance
mix of the company.
 84 Financial Management

Leverage

Finacial Operating
Leverage Leverage

Composite
Leverage

Fig. 7.1 Types of Leverage

The company may use finance or leverage or operating leverage, to increase the EBIT
and EPS.

OPERATING LEVERAGE
The leverage associated with investment activities is called as operating leverage. It is caused
due to fixed operating expenses in the company. Operating leverage may be defined as the
company’s ability to use fixed operating costs to magnify the effects of changes in sales on
its earnings before interest and taxes. Operating leverage consists of two important costs
viz., fixed cost and variable cost. When the company is said to have a high degree of
operating leverage if it employs a great amount of fixed cost and smaller amount of variable
cost. Thus, the degree of operating leverage depends upon the amount of various cost
structure. Operating leverage can be determined with the help of a break even analysis.
Operating leverage can be calculated with the help of the following formula:
C
OL =
OP
Where,
OL = Operating Leverage
C = Contribution
OP = Operating Profits
Degree of Operating Leverage
The degree of operating leverage may be defined as percentage change in the profits resulting
from a percentage change in the sales. It can be calculated with the help of the following
formula:
Percentage change in profits
DOL = Percentage change in sales
 Leverage 85

Exercise 1
From the following selected operating data, determine the degree of operating leverage.
Which company has the greater amount of business risk? Why?

Company A Company B
Rs. Rs.
Sales 25,00,000 30,00,000
Fixed costs 7,50,000 15,00,000

Variable expenses as a percentage of sales are 50% for company A and 25% for
company B.
Solution
Statement of Profit
Company A Company B
Rs. Rs.
Sales 25,00,000 30,00,000
Variable cost 12,50,000 7,50,000
Contribution 12,50,000 22,50,000
Fixed cost 7,50,000 15,00,000
Operating Profit 5,00,000 7,50,000

Contribution
Operating Leverage =
Operating Profit

12,50,000
“A” Company Leverage = 5,00,000 = 2.5
2,25,000
“B” Company Leverage = =3
7,50,000
Comments
Operating leverage for B Company is higher than that of A Company; B Company has a
higher degree of operating risk. The tendency of operating profit may vary portionately
with sales, is higher for B Company as compared to A Company.

Uses of Operating Leverage

Operating leverage is one of the techniques to measure the impact of changes in sales
which lead for change in the profits of the company.
If any change in the sales, it will lead to corresponding changes in profit.
Operating leverage helps to identify the position of fixed cost and variable cost.
 86 Financial Management

Operating leverage measures the relationship between the sales and revenue of the
company during a particular period.
Operating leverage helps to understand the level of fixed cost which is invested in the
operating expenses of business activities.
Operating leverage describes the over all position of the fixed operating cost.

FINANCIAL LEVERAGE
Leverage activities with financing activities is called financial leverage. Financial leverage
represents the relationship between the company’s earnings before interest and taxes (EBIT)
or operating profit and the earning available to equity shareholders.
Financial leverage is defined as “the ability of a firm to use fixed financial charges to
magnify the effects of changes in EBIT on the earnings per share”. It involves the use of
funds obtained at a fixed cost in the hope of increasing the return to the shareholders.
“The use of long-term fixed interest bearing debt and preference share capital along with
share capital is called financial leverage or trading on equity”.
Financial leverage may be favourable or unfavourable depends upon the use of fixed
cost funds.
Favourable financial leverage occurs when the company earns more on the assets
purchased with the funds, then the fixed cost of their use. Hence, it is also called as positive
financial leverage.
Unfavourable financial leverage occurs when the company does not earn as much as
the funds cost. Hence, it is also called as negative financial leverage.
Financial leverage can be calculated with the help of the following formula:
OP
FL =
PBT
Where,
FL = Financial leverage
OP = Operating profit (EBIT)
PBT = Profit before tax.
Degree of Financial Leverage
Degree of financial leverage may be defined as the percentage change in taxable profit as a
result of percentage change in earning before interest and tax (EBIT). This can be calculated
by the following formula

Percentage change in taxable Income

DFL=
Precentage change in EBIT
 Leverage 87

Alternative Definition of Financial Leverage

According to Gitmar, “financial leverage is the ability of a firm to use fixed financial changes
to magnify the effects of change in EBIT and EPS”.
EBIT
FL =
EPS
Where,
FL = Financial Leverage
EBIT = Earning Before Interest and Tax
EPS = Earning Per share.
Exercise 2
A Company has the following capital structure.

Rs.
Equity share capital 1,00,000
10% Prof. share capital 1,00,000
8% Debentures 1,25,000

The present EBIT is Rs. 50,000. Calculate the financial leverage assuring that the
company is in 50% tax bracket.
Solution

Statement of Profit Rs.

Earning Before Interest and Tax (EBIT) 50,000
(or) Operating Profit
. Interest on Debenture
1,25,000 × 8 × 100
Earning before Tax (EBT) 10,000
40,000
Income Tax 20,000
Profit
20,000

Operating Profit (OP)

Financial leverage =
Profit BeforeTax(PBT)
50,000
= 40,000
=1.25

Uses of Financial Leverage

Financial leverage helps to examine the relationship between EBIT and EPS.
 88 Financial Management

Financial leverage measures the percentage of change in taxable income to the percentage
change in EBIT.
Financial leverage locates the correct profitable financial decision regarding capital
structure of the company.
Financial leverage is one of the important devices which is used to measure the fixed
cost proportion with the total capital of the company.
If the firm acquires fixed cost funds at a higher cost, then the earnings from those
assets, the earning per share and return on equity capital will decrease.
The impact of financial leverage can be understood with the help of the following
exercise.
Exercise 3
XYZ Ltd. decides to use two financial plans and they need Rs. 50,000 for total investment.

Particulars Plan A Plan B

Debenture (interest at 10%) 40,000 10,000
Equity share (Rs. 10 each) 10,000 40,000
Total investment needed 50,000 50,000
Number of equity shares 4,000 1,000

The earnings before interest and tax are assumed at Rs. 5,000, and 12,500. The tax
rate is 50%. Calculate the EPS.
Solution
When EBIT is Rs. 5,000

Particulars Plan A Plan B

Earnings before interest and tax (EBIT) 5,000 5,000
Less : Interest on debt (10%) 4,000 1,000
Earnings before tax (EBT) 1,000 4,000
Less : Tax at 50% 500 2,000
Earnings available to equity shareholders. Rs.500 Rs.2,000
No. of equity shares 1,000 4,000
Earnings per share (EPS) Rs. 0.50 Rs. 0.50
Earnings/No. of equity shares

When EBIT is Rs. 12,500

Particulars Plan A Plan B

Earnings before interest and tax (EBIT). 12,500 12,500
Less: Interest on debt (10%) 4,000 1,000
(Contd....)
Leverage 89

Earning before tax (EBT) 8,500 11,500

Less : Tax at 50% 4,250 5,750
Earnings available to equity shareholders 4,250 5,750
No. of equity shares 1,000 4,000
Earning per share 4.25 1.44

DISTINGUISH BETWEEN OPERATING LEVERAGE AND FINANCIAL LEVERAGE

Operating Leverage/Financial Leverage
Operating Leverage Financial Leverage
1. Operating leverage is associated with 1. Financial leverage is associated with financing
investment activities of the company. activities of the company.
2. Operating leverage consists of fixed 2. Financial leverage consists of operating profit
operating expenses of the company. of the company.
3. It represents the ability to use fixed 3. It represents the relationship between EBIT
operating cost. and EPS.
4. Operating leverage can be calculated by 4. Financial leverage can be calculated by
C OP
OL = . FL = .
OP PBT
5. A percentage change in the profits resulting 5. A percentage change in taxable profit is the
from a percentage change in the sales is result of percentage change in EBIT.
called as degree of operating leverage.
6. Trading on equity is not possible while the 6. Trading on equity is possible only when the
company is operating leverage. company uses financial leverage.
7. Operating leverage depends upon fixed 7. Financial leverage depends upon the
cost and variable cost. operating profits.
8. Tax rate and interest rate will not affect the 8. Financial leverage will change due to tax rate
operating leverage. and interest rate.

EBIT - EPS Break even chart for three different financing alternatives
X1
X2

DR = 70%
EPS DR = 30%

X3

DR = 0%

EBIT
C1 C2 C3

Fig. 7.2 EBIT - EPS Break Even Chart

 90 Financial Management

Where,
DR= Debt Ratio
C1, C2, C3 = Indifference Point
X1, X2, X3 = Financial BEP
Financial BEP
It is the level of EBIT which covers all fixed financing costs of the company. It is the level
of EBIT at which EPS is zero.

Indifference Point
It is the point at which different sets of debt ratios (percentage of debt to total capital employed
in the company) gives the same EPS.

COMBINED LEVERAGE
When the company uses both financial and operating leverage to magnification of any
change in sales into a larger relative changes in earning per share. Combined leverage is
also called as composite leverage or total leverage.
Combined leverage express the relationship between the revenue in the account of
sales and the taxable income.
Combined leverage can be calculated with the help of the following formulas:
CL = OL × FL
C OP C
CL = × =
OP PBT PBT
Where,
CL = Combined Leverage
OL = Operating Leverage
FL = Financial Leverage
C = Contribution
OP = Operating Profit (EBIT)
PBT = Profit Before Tax
Degree of Combined Leverage
The percentage change in a firm’s earning per share (EPS) results from one percent change
in sales. This is also equal to the firm’s degree of operating leverage (DOL) times its degree
of financial leverage (DFL) at a particular level of sales.

Percentage change in EPS

Degree of contributed coverage =
Percentage change in sales
 Leverage 91

Exercise 4
Kumar company has sales of Rs. 25,00,000. Variable cost of Rs. 12,50,000 and fixed
cost of Rs. 50,000 and debt of Rs. 12,50,000 at 8% rate of interest. Calculate combined leverage.
Solution

Statement of Profit

Sales 25,00,000
Less: Variable cost 15,00,000
Contribution 10,00,000
Less: Fixed cost 5,00,000
Operating Profit 5,00,000

Combined leverage =Operating leverage×Financial leverage

Calculation of financial leverage
Contribution 10,00,000
= =2
Operating Profit 5,00,000

Calculation of financial leverage

Earning before Interest and Tax (EBIT) 5,00,000
Less: Interest on Debenture ( 8% of 12,50,000) 1,00,000
Earnings before Tax 4,00,000

Operating Profit 5,00,000

Operating leverage = = =1.25
Earning Before Tax 4,00,000
Combined leverage = 2 × 1.25 = 2.5
Exercise 5
Calculate the operating, financial and combined leverage under situations 1 and 2 and
the financial plans for X and Y respectively from the following information relating to the
operating and capital structure of a company, and also find out which gives the highest and
the least value ? Installed capacity is 5000 units. Annual Production and sales at 60% of
installed capacity.
Selling price per unit Rs. 25
Variable cost per unit Rs. 15
Fixed cost:
Situation 1 : Rs. 10,000
Situation 2 : Rs. 12,000
 92 Financial Management

Capital structure:
Financial Plan

X (Rs.) Y (Rs.)

Equity 25,000 50,000

Debt (cost 10%) 50,000 25,000
75,000 75,000

Solution
Annual production and sales 60% of 5,000 = 3000 Unit
Contribution per Unit Rs.
Selling Price 25 Per Unit
Variable Price 15 Per Unit
10 Per Unit
Total contribution is 3000 Units×Rs. 10=Rs. 30,000
Computation of leverage.
Financial plan

PLAN-X PLAN-Y
Situation 1 Situation 2 Situation 1 Situation 2
Contribution 30000 30000 30000 30000
Fixed cost operating
profit (or) EBIT 10000 12000 10000 12000
20000 18000 20000 18000
Interest on Debts
10% of 50,000 5000 5000 2500 2500
10% of 25,000
Earnings before Tax 15000 13000 17500 15500
(i) Operating Leverage
Contribution 30000 30000 30000 30000
20000 18000 20000 18000
= 1.5 1.67 1.5 1.67
(ii) Financial Leverage
Operating Profit (op) 20000 18000 20000 18000
Profit Before Tax (PBI) 15000 13000 17500 15500
(iii) Combined leverage
OL × FL = 1.5 × 1.33 1.67 × 1.38 1.5 × 1.14 1.67 × 1.16
1.995 2.30 1.71 1.94
Highest and least value of combined leverage.
Highest Value = 2.30 under situation 2 plan X.
Least Value = 1.71 under situation 1 plan Y.
 Leverage 93

Exercise 6
Calculate operating, financial and combined leverages under situations when fixed costs are:
(i) Rs. 5,000 and
(ii) Rs. 10,000 and financial plans 1 and 2 respectively from the following information
pertaining to the operating and capital structure of a textile company :
Rs.
Total Assets 30,000
Total Assets turnover 2
Variable cost as percentage of sales 60

Capital structure Financial Plan

1 2

Rs. Rs.
Equity 30,000 10,000
10% debentures 10,000 30,000

Solution
Computation of Leverage
Financial Plan

Plan 1 2
Situation i ii i ii
Sales 60,000 60,000 60,000 60,000
Less : Variable cost 36,000 36,000 36,000 36,000
Contribution 24,000 24,000 24,000 24,000
Less : Fixed cost 5,000 10,000 5,000 10,000
Operating profit (EBIT) 19,000 14,000 19,000 14,000
Less : Interest 1,000 1,000 3,000 3,000
Profit before tax (PBT) 18,000 13,000 16,000 11,000
Operating leverage 24,000 24,000 24,000 24,000
Contribution 19,000 14,000 19,000 14,000
EBIT 1.26 1.71 1.26 1.71
Financial leverage 19,000 14,000 19,000 14,000
EBIT 18,000 13,000 16,000 11,000
PBT 1.05 1.07 1.18 1.27
Combined leverage 1.32 1.83 1.49 2.17

WORKING CAPITAL LEVERAGE

One of the new models of leverage is working capital leverage which is used to locate the
investment in working capital or current assets in the company.
Working capital leverage measures the sensitivity of return in investment of charges in
the level of current assets.
 94 Financial Management

WCL = Percentage Change in ROI

Percentage Change is WC
If the earnings are not affected by the changes in current assets, the working capital
leverage can be calculated with the help of the following formula.
CA
WCL =
TA ± DCA
Where,
CA = Current Assets
TA = Total Assets
DCA = Changes in the level of Current Assets
Exercise 7
The following information is available for two companies.

X Ltd. Y Ltd.

Fixed Assets Rs. 4,00,000 1,00,000

Current Assets Rs. 10,00,000 4,00,000
Total Assets Rs. 14,00,000 14,00,000
Earning before interest and taxes Rs. 1,50,000 1,50,000

You are required to compare the sensitivity earnings of the two companies for 30%
charge in the level of their current assets.

Solution

Current Assets
Working capital leverage =
Total Assets ± DCA
1,00,000
X Ltd. =
14,00,000 – 3,00,000

10,00,000
=
11,00,000
= 0 .90
4,00,000
Y Ltd. =
14,00,000 – 1,20,000

4,00,000
=
12,80,000
= 0.3125
 Leverage 95

Looking at the working capital leverage of the two companies, we can say that the
sensitivity of earnings for charge on the level of current assets of X Ltd. is a greater than of
Y Ltd.
Exercise 8
Calculate operating leverage and financial leverage under situations A, B and C and
financial plans 1, 2 and 3 respectively from the following information relating to the operating
and financial leverage which give the highest value and the least value.

Installed capacity (units) 1,200

Actual production and sales (units) 800
Selling price per unit (Rs.) 15
Variable cost per unit (Rs.) 10
Fixed costs (Rs.) Situation A 1,000
Situation B 2,000
Situation C 3,000

Capital Structure Financial Plan

1 2 3

Equity Rs. 5,000 Rs. 7,500 Rs. 2,500

Debt Rs. 5,000 Rs. 2,500 Rs. 7,500
Cost of debt 12 per cent
(for all plans)
(MBA – P.U. Nov. 2005)

Solution
A B C
S – VC 4,000 4,000 4,000
EBIT 3,000 2,000 1,000
S − VC
DOL = 1.33 2 4
EBIT
1 2 3

Situation A
EBIT 3,000 3,000 3,000
Less : Interest 600 300 900

EBT 2,400 2,700 2,100

Financial Leverage 1.25 1.11 1.43

Situation B
EBIT 2,000 2,000 2,000
Less : Interest 600 300 900
 96 Financial Management

EBT 1,400 1,700 1,100

Financial Leverage 1.43 1.18 1.82

Situation C
EBIT 1,000 1,000 1,000
Less : Interest 600 300 900

EBT–I 400 700 100

Financial Leverage 2.5 1.43 10

Exercise 9
‘ XYZ’ company has a choice of the following three financial plans. You are required to
calculate the financial leverage in each case.

Plan I Plan II Plan III

Equity capital Rs. 2,000 Rs. 1,000 Rs. 3,000
Debt Rs. 2,000 Rs. 3,000 Rs. 1,000
EBIT Rs. 400 Rs. 400 Rs. 400

Interest @10% per annum on debts in all cases.

Solution
Plan I Plan II Plan III
Rs. Rs. Rs.
EBIT 400 400 400
Less Interest-(I) 200 300 100
EBIT–I 200 100 300
FL 2 4 1.33

MODEL QUESTIONS

1. Write a note on trading on equity.

2. What is meant by working capital leverage?
3. What is leverage? Mention different types of leverage?
4. Explain the operating leverage.
5. Discuss the concept of financial leverage.
6. How compared leverage is calculated?
7. Explain the working capital leverage.