Lecture 10 leverage

Amity Business School

1

Amity Business School Semester II

FINANCIAL MANAGEMENT

(Leverage Analysis)


Leverage reflects the responsiveness or influence of one financial variable over some other financial variable.

% Change in dependent variable Degree of Leverage =

% Change in independent variable

* The two variables, for which the relationship is to be established and measured, should be interrelated, otherwise, the leverage study may not have any useful purpose

What is Leverage?


In Finance, leverage refers to the use of fixed costs to magnify the potential return to a firm

Types of fixed costs:

Fixed Operating costs e.g.- rent, depreciation

Fixed Financial costs e.g.- interest costs on long term debt (Debentures) ; Preference Dividend

Total Fixed Cost – Sum total of the above two


Classification of Leverage

Just as fixed costs may be broadly classified into:

• Operating Fixed Cost; and

• Financial Fixed Cost,• Total Fixed Cost

Likewise, leverage may be classified into:

• Operating Leverage• Financial Leverage• Combined Leverage / Total Leverage


Sales Revenues (S) EBIT

- Variable Cost (V) - Interest

Contribution (PBT) Profit Before Tax

- Fixed Cost (F) - Tax

EBIT (PAT) Profit After Tax

- Preference Dividend

Earnings available for equity shareholders

EPS = Earnings available for equity shareholders No. of Shares


• When Sales level increases or decreases, the EBIT also changes.

• The “Operating Leverage” measures the relationship between the sales revenue and the EBIT.


Degree of Operating Leverage

• The degree of operating leverage (DOL) can be calculated as:

eentVariablinIndepend

tVariableinDependen

Sales

EBITDOL

∆∆=

∆∆=

%

%

%

%


Operating leverage is also calculated as:-

Contribution

Operating Leverage =

EBIT

Amity Business SchoolTipWhenever, there is a change in the “level of activity” and Operating Leverage is to be found out, then use the formula-

But, whenever Operating Leverage is to be found out for “status-quo” or for the “current level of activity” then use the formula

Contribution

Operating Leverage (OL) = EBIT

Sales

EBITDOL

∆∆=

%

%


Particulars Base Level New Level

1. Units sold 1,000 1,100

2. Sales price per unit Rs 10 Rs 10

3. Variable cost per unit 6 6

4. Fixed operating cost Nil Nil

Calculate Operating Leverage from the following data-


Solution

EBIT for Various Sales Volume

Particulars Base Level New Level

Sales revenues Rs 10,000 Rs 11,000

Less: Variable costs (6,000) (6,600)

Less: Fixed costs — —

EBIT 4,000 4,400

DOL = ( 400 / 4000 ) x ( 10,000 / 1,000 ) = 1

There is no operating leverage.


Conclusion;

Analysis of operating leverage of a firm is very useful to the financial manager. It tells the impact of change in sales on the level of operating profits of the firm.

A firm with high DOL can experience a magnified effect on EBIT for even a small change in sales Level.

Higher DOL can dramatically increase the operating profit. But if sales decline ????????

Therefore the firms should always try to avoid operating under high DOL as high DOL Condition is a high risk situation.

•Operating leverage exists only when there are fixed operating costs. •If there are no fixed operating costs, there will be no operating leverage.


Q1. Calculate the operating Leverage from the following data:Sales $50000Variable Cost 60%Fixed Costs $12000.

Q2. Calculate & interpret the Degree of Operating LeverageParticulars Amount ($)Sales 1050000Variable Cost 767000Fixed Cost 75000EBIT 208000Interest 110000Taxes (30%) 29400Net Income 68600


Q3. Calculate the operating leverage & interpret the result:2010 2011

Sales 1000 units 1100 unitsSp per unit $10 $10Variable cost per unit $6 $6Fixed Cost Nil Nil

Q4. Calculate the operating Leverage from the following information:

Sales 1000 units 1400 unitsVariable cost $7 per unit $7 per unitFixed cost $1000 $1000Selling price per unit is $10.

Education

Lecture 10 leverage