analysis of operating and financial leverages

7/29/2019 Analysis of Operating and Financial Leverages

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Analysis of operating and

financial leverages


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MEANING

The term leverage refers to meansof accomplishing power for gainingan advantage. Leverage refers to theability of a firm in employing longterm funds having a fixed cost, toenhance returns to the owners. In

other word leverage is theemployment of fixed assets or fundsfor which a firm has to meet fixedcosts or fixed rate of interest

obligation irrespective of the level of


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OPERATING LEVERAGE

Operating leverage is concerned withthe operation of any firm.The coststructure of any firm gives rise tooperating leverage because of theexistence of fixed nature of costs.

This leverage relates to the sale and

profit varaiation.

Operating Leverage = Contribution


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DEGREE OF OPERATINGLEVERAGE Percentage change in EBIT

% EBIT

= ________________________ OR

________Percentage change in sales

% Q

The degree of operating leverage canalso be expressed as follows:

Q (P V)

DOL = _________


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below:

_____________________________

___________________________

Units Manufactured and sold Firm X (20,000 )Firm Y(20,000)

Direct Material 1010

Direct Labour 5

5


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Solution:

Particulars Firm X Firm Y

Contribution for20,000 Units

2,00,000 2,00,000

Less:Fixed overheads1,00,000 1,50,000

EBIT 1,00,000 50,000

Operating

Leverage(Contribution orEBIT)

2,00,000/1,

00,000)= 2

2,00,000/50,0

00=4


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Analysis firm Ys operating

Leverage is twice of firm X , as thefixed overheads are higher. Thehigher the operating leverage ratio

the situation is more risky. while alow ratio indicates a largerabsorption capacity of a firm in timesof adversity.


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Disadvantages

The study of operating leveragesuffers from the following shortfalls:

(i) the reliability of operatingleverage rests to a large extent onthe correctness of the fixed costsidentified with a product. Faulty

apportionment would distort theusefulness of the ratio.

(ii) the published accounts does not

give details of the fixed cost incurred


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FINANCIAL LEVERAGE

The ratio indicates the effects onearnings by rise of fixed cost funds. Itrefers to the use of debt in thecapital structure. Financial leveragearises when a firm deploys debtfunds with fixed charge. The ratio is

expressed as follows:Financial Leverage = EBIT / EBT

The higher the ratio, the lower the

cushion for paying interest on


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DEGREE OF FINANCIALLEVERAGE

% change in EPS

= ____________________

% change in EBIT

or

% EPS

________

% EBIT

OR


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EPS can be ascertained as below:

EPS = (EBIT I )(I t) Dp

___________________

NThe degree of financial leveragemeasures the responsivess of EPS tochange in EBIT. Degree of financialleverage can also be expressed asfollows:

DFL = EBIT


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Where, DFL = Degree of financial

leverageEBIT = Earnings before Interest andTax

I = Interest on long term debtt= Corporate income tax rate

Dp = Preference Dividend


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Illustration :6.2

The following information is availablefor Crompton Ltd., for the year ended31st March 2009.

Interest on debt Rs. 4,00,000

Preference dividend Rs.2,00,000

Corporate tax rate 40%Calculate the degree of financialleverage

(i) If EBIT is Rs.10,00,000 and (ii) if


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Solution:

(i) DFL if EBIT is Rs. 10,00,000

10,00,000

=_________________________________

0,00,000 4,00,000

[2,00,000/1 0.40] = 3.75(ii) DFL if EBIT is RS.15,00,000

15,00,000

=


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Total Leverage

Total leverage may be defined as thepotential use of fixed costs, bothoperating and financial , whichmagnifies the effect of sales volumechange on the EPS of the firm. Thetotal leverage is also called as

combined leverage. The methods ofproduction employed which arereflected in the asset structure of thefirm , influence its operating leverage.

For example, substituting machinery


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For example, substituting debt forcommon stock holders equity increasesfinancial leverage. Degree of totalleverage can be calculated as follows:

DTL = Operating Leverage xFinancial Leverage

or = Contributionx EBIT

________________ _____

EBIT


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Substituting the value of EPS, we get:

DTL = Q (P V)

_____________________

Q(P V) F I DP

____

1 t

Where, Q = Quantity produced and sold

P = Selling price per unit

I = Interest cost on debt

t = Income- tax rate

V = Variable cost per unit

F = Fixed operating cost

Dp = Preference dividend

DTL measures the sensitivity of EPS to change in quantityproduced and sold.


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Illustration 6.4

Consider the following information forWatson Ltd.

Selling price per unitRs. 200

Variable cost per unit

Rs. 120Fixed cost Rs.20,00,000

Interest on debt Rs.

12,00,000


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Solution

DTL = 1,20,000 (200 120)

[ 1,20,000 ( 200 120)] 20,00,000 12,00,000 8,00,000

( 1 0.40)

= 96,00,000

96,00,000 20,00,000 12,00,000 13,33,333 =96,00,000

5 0,66,667 = 1.89


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Operating

FinancialEffect/Conclusion

LeverageLeverage

(1)High High

Very risky, High


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Illustration :6.2

The following information is availablefor Crompton Ltd., for the year ended31st March 2009.

Interest on debt Rs. 4,00,000

Preference dividend Rs.2,00,000

Corporate tax rate 40%Calculate the degree of financialleverage

(i) If EBIT is Rs.10,00,000 and (ii) if


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Solution:

(i) DFL if EBIT is Rs. 10,00,000

10,00,000

=_________________________________

0,00,000 4,00,000

[2,00,000/1 0.40]= 3.75

(ii) DFL if EBIT is RS.15,00,000

15 00 000

analysis of operating and financial leverages

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