A business concern can augment its funds for investment by increasing the claims of owners or creditors or both. The owners' claims increase when the firm raises funds by issuing equity shares or ploughing back of profits; whereas the creditors' claims increase by borrowing through issuing debentures or raising long-term loans. The mix of these various sources of funds is known as financial structure or capital structure. Financing or capital structure decisions are very significant for the management of a firm. These decisions affect the debt-equity mix of the firm. If the debt capital is more than owners' funds, it increases the shareholders return and risk. On the other hand, if the proportion of shareholders' funds is more than debt capital, it decreases both owners' return as well as their risk. Therefore, the concept that is used to study the effects of various mix of debt and equity on the shareholders' return and risk in the capital structure of a firm is called leverage.
Meaning of Leverage
However, in financial management, it is used in specific sense. Leverage implies the ability of a firm to use fixed cost assets or funds in order to magnify the return to its shareholders. In other words, ‘leverage means theemployment of assets or funds for which the firm pays a fixed cost fixed return. The fixed cost or return may be thought of as the fulcrum a lever.’
Thus, leverage arises when the firm uses an asset or funds for which it pays a fixed cost or return. If the firm employs an asset (land, building; machine) which has a fixed cost, it is known as ‘fixed operating cost' and if the firm uses a source of fund (debenture), which has fixed cost (interest), it is termed as‘fixed financial cost'. If a firm is not required to pay any fixed cost or return, it will have no leverage.
Operating Leverage
As we know, the cost structure of a firm comprises two types of costs i.e.
(i) fixed costs; and
(ii) variable costs
Fixed costs are those costs that are not affected by the change in volume of production or sales, where variable costs vary in proportion to change in volume of production or sales. When a firm uses such an asset for which it has to pay fixed costs, then it is said that operating leverage exists in the firm.In other words, the extent of fixed costs in operating activities of a firm determines the operating leverage. If the fixed operating costs are more as compared to variable operating costs, the operating leverage will be high and vice-versa: Thus, the term ‘operating leverage’ refers to the sensitivity of operating profits to changes in sales.
For example; if the sales increase by ‘say' 25% and the operating profit increases by 100%, it is a case of high operating leverage. If there are no fixed costs, there will be no operating leverage and the rate of change in operating profits will be exactly equal to the rate of change in sales. However, when fixed costs exist, there is a positive operating leverage and the change in operating profits is larger than the change in sales. Thus, operating leverage may be defined as a firm's ability to use fixed cost assets (plant and machinery) to magnify the effect of changes in sales on operating profits or earnings before interest and tax (EBIT). In other words, operating leverage is defined as the Use of fixed operating costs to magnify a change in profits relative to a given change in sates.The foregoing concept and working of operating leverage is explained with the help of following example:
Example
A firm sells 80,000 units of a product. The per unit selling price is Rs. 8 and variable cost Rs. 2. If fixed costs for the year amounts to Rs.3,00,000, the effect on profit will be as follows, if it sells (i) 96,000 units; (ii) 64,000 units.
Meaning of Leverage
However, in financial management, it is used in specific sense. Leverage implies the ability of a firm to use fixed cost assets or funds in order to magnify the return to its shareholders. In other words, ‘leverage means theemployment of assets or funds for which the firm pays a fixed cost fixed return. The fixed cost or return may be thought of as the fulcrum a lever.’
Thus, leverage arises when the firm uses an asset or funds for which it pays a fixed cost or return. If the firm employs an asset (land, building; machine) which has a fixed cost, it is known as ‘fixed operating cost' and if the firm uses a source of fund (debenture), which has fixed cost (interest), it is termed as‘fixed financial cost'. If a firm is not required to pay any fixed cost or return, it will have no leverage.
Operating Leverage
As we know, the cost structure of a firm comprises two types of costs i.e.
(i) fixed costs; and
(ii) variable costs
Fixed costs are those costs that are not affected by the change in volume of production or sales, where variable costs vary in proportion to change in volume of production or sales. When a firm uses such an asset for which it has to pay fixed costs, then it is said that operating leverage exists in the firm.In other words, the extent of fixed costs in operating activities of a firm determines the operating leverage. If the fixed operating costs are more as compared to variable operating costs, the operating leverage will be high and vice-versa: Thus, the term ‘operating leverage’ refers to the sensitivity of operating profits to changes in sales.
For example; if the sales increase by ‘say' 25% and the operating profit increases by 100%, it is a case of high operating leverage. If there are no fixed costs, there will be no operating leverage and the rate of change in operating profits will be exactly equal to the rate of change in sales. However, when fixed costs exist, there is a positive operating leverage and the change in operating profits is larger than the change in sales. Thus, operating leverage may be defined as a firm's ability to use fixed cost assets (plant and machinery) to magnify the effect of changes in sales on operating profits or earnings before interest and tax (EBIT). In other words, operating leverage is defined as the Use of fixed operating costs to magnify a change in profits relative to a given change in sates.The foregoing concept and working of operating leverage is explained with the help of following example:
Example
A firm sells 80,000 units of a product. The per unit selling price is Rs. 8 and variable cost Rs. 2. If fixed costs for the year amounts to Rs.3,00,000, the effect on profit will be as follows, if it sells (i) 96,000 units; (ii) 64,000 units.
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| Operating Profit at Various Levels of Sales |
Computation of Operating Leverage
Operating leverage may be calculated using break-even analysis. Accordingly, the operating leverage for a given sales level will be determined by dividing the contribution (sales-variable cost) by the operating profit
(contribution − fixed cost).
Expressed as a formula:
Operating Leverage = Contribution/ Operating Profits
or
C/EBIT
or
OL Leverage = (Sales/ Contribution)−(Variable Cost/Fixed Costs)
or
(S − V)/(S − V − F)
In the above example, the operating leverage at 80,000 units will be Rs. 4,80,000 = 3.2 Operating Leverage = Rs. 1, 50,000.
In case the contribution exceeds the fixed costs (C > F), there is favourable operating leverage. In a reverse case, when fixed costs are more than contribution (C < F), the operating leverage will be termed as unfavourable.Operating leverage involves the possibility of operating risk i.e. the risk of being unable to cover the operating costs of business. It is a function of three variables i.e. (i) the amount of fixed costs, (ii) the contribution margin, and
(iii) the volume of sales.Financial Analysis
Degree of Operating Leverage
The multiplier effect resulting from the use of fixed operating costs can be measured by the degree of operating leverage. The degree of operating leverage (DOL) at any level of output is expressed as the ratio of the percentage change in operating profits to percentage change in sales.
The following formula can be used for its calculation: Degree of Operating Leverage (DOL)
Percentage Change in Profits/ Percentage Change in Sales
or
DOL =% Change in EBIT/% Change in Sales
The degree of operating leverage 3.2 shows that if sales increase by rupee one; the profit would increase by Rs. 0.32. The operating leverage on sales of 80,000 units is 3.2 and it remain same 3.2 even if sales increases by 20%. Thus, it is clear that this level of sales, for each 1% change, the profits will change by 3.2%.
Financial Leverage
Financial leverage is related to financing activities of the firm. From the view of costs of charges, a firm can raise finance from the sources carry fixed financial costs and which do not involve any fixed costs. Financial leverage arises from the presence of fixed financial costs in the stream of the firm or due to presence of fixed return securities in capital structure of the company. Fixed cost/charge securities are debentures and preference shares. The rate of interest on debt is fixed and to be paid irrespective of the amount of earnings.The rate of dividend on preference shares is also fixed, though preference dividend is paid when the company earns profits. The rate of dividend on equity shares is not fixed and the residual earnings (after interest, tax and preference dividend) belong equity shareholders. When the rate of company's earnings is higher than the rate of interest and preference dividend, there is an increase in earnings per equity share. This impact of fixed cost securities on the earnings, per share is the result of financial leverage. Thus, financial leverage is defined as, the firm's ability to use fixed financial charges/costs to magnify the effect of changes in earnings before interest and tax (EBIT) on firm's earnings per share. In other words, the principle of financial leverage analyses the effects of change in EBIT on firm's
EPS due to the use of fixed cost bearing sources of capital in its capital structure.Financial leverage may be favourable and unfavourable. If the earnings made by the use of fixed interest bearing securities is more than their fixed costs, the firm is considered to have favourable financial leverage or trading on equity.If the firm earns less than the cost of borrowed funds, the firm is said to have an unfavourable financial leverage.
Computation of Financial Leverage
At single level of profit, the financial leverage may be calculated by using the following formula:
Financial Leverage : Operating profit or Earnings before Interest & Tax/ Earning profit or Earnings before Interest & Tax
FL =EBIT/EBT
or
EBIT/(EBIT − 1)
Here 1 means fixed financial expenses i.e. interest and dividend on preferences shares.
Degree of Financial Leverage
The degree of financial leverage can be measured in any of the two ways.The degree of financial leverage can be measured by the percentage change in earnings per share in relation to the percentage change in earnings before interest and tax. Accordingly, the formula would be as under:
Degree of Financial Leverage =Percentage Change in EPS/Percentage Change in EBIT
Degree of financial leverage may be defined as the percentage change in taxable profits as a result of percentage change in operating profits.
Accordingly, the formula can be put as under:
Degree of Financial Leverage =Percentage Change in EPS/Percentage Change in EBIT
The quotient should be greater than one. If the quotient does not exceed one, there will be no financial leverage.
At single level of profit, the financial leverage may be calculated by using the following formula:
Financial Leverage : Operating profit or Earnings before Interest & Tax/ Earning profit or Earnings before Interest & Tax
FL =EBIT/EBT
or
EBIT/(EBIT − 1)
Here 1 means fixed financial expenses i.e. interest and dividend on preferences shares.
Degree of Financial Leverage
The degree of financial leverage can be measured in any of the two ways.The degree of financial leverage can be measured by the percentage change in earnings per share in relation to the percentage change in earnings before interest and tax. Accordingly, the formula would be as under:
Degree of Financial Leverage =Percentage Change in EPS/Percentage Change in EBIT
Degree of financial leverage may be defined as the percentage change in taxable profits as a result of percentage change in operating profits.
Accordingly, the formula can be put as under:
Degree of Financial Leverage =Percentage Change in EPS/Percentage Change in EBIT
The quotient should be greater than one. If the quotient does not exceed one, there will be no financial leverage.
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