Leverages:

Leverage results from using borrowed capital as a funding source when investing to expand the firm's asset base and generate returns on risk capital. Leverage is an investment strategy of using borrowed money-specifically, the use of various financial instruments or borrowed capital - to increase the potential return of an investment.

 Leverage can also refer to the amount of debt a firm uses to finance assets.

 Leverage refers to the use of debt (borrowed funds) to amplify returns from an   investment or project.

 Leverage is used to describe the firm’s ability to use fixed cost assets or funds to magnify the return to its owners.

“The employment of an asset or funds for which the firm pays a fixed cost or fixed return.”

  Leverage is the employment of fixed assets or funds for which a firm has to meet fixed costs or fixed rate of interest obligation irrespective of the level of activities or      the level of operating profit.

Types of Leverage

1. Operating Leverage
2. Financial Leverage
3. Combined or Composite Leverage

Operating Leverage

Operating Leverage is defined as “the firm’s ability to use fixed operating costs to magnify effects of changes in sales on its earnings before interest and taxes”. In other words operating leverage is the tendency of the operating profit to vary disproportionately with sales. It is said to exist when a firm has to pay fixed cost regardless of volume of output or sales.The operating leverage shows the relationship between the changes in sales and the changes in fixed operating income. Thus, the operating leverage has an impact mainly on fixed costs and also on variable costs and contribution. Of course, there will be no operating leverage if there are no fixed operating costs.

Operating Leverage can be calculated as:

OL= Contribution or ‘C’/ EBIT or Operating Profit (OP)

Degree of Operating Leverage = % Change in EBIT/% Change in Sales

 Where,

OL = Operating Leverage

C = Contribution

OP = Operating Profits

Utilizing a higher degree of operating leverage raises the risk of cash flow problems that results from errors in forecasts of future sales. One possible effect caused by the presence of operating leverage is that a change in the amount of sales results in a "more than proportional" change in operating profit (or loss).

Uses of Operating Leverage

Operating leverage is one of the procedures to measure the impact of changes in sales which lead for change in the profits of the company. If there is any change in the sales, it will lead to corresponding changes in profit. Operating leverage assists to identify the position of fixed cost and variable cost. 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 defines the overall position of the fixed operating cost.

Effects of Operating Leverage

A high operating leverage entails that company has increased production without investing in additional fixed costs. As production rises, managers are in effect spreading fixed costs across a greater number of units, so the additional units have a lower ratio of fixed costs to total costs. When demand for company product increases, then experts can easily ramp up production by increasing variable costs; Company's fixed assets allow magnifying production. Managers can increase production as long as their higher variable costs do not cause total costs to exceed their sales revenues. However, at the time of a recession, high operating leverage is risky.

Financial leverage

Financial leverage characterizes the relationship between the company's earnings before interest and taxes (EBIT) or operating profit and the earning available to equity shareholders. Financial leverage increases as how earnings per share (EPS) change as a result of changes in EBIT where the fixed cost is that of financing, specifically interest costs. Financial Leverage is the use of fixed financing costs by the firm. Financial leverage is attained by choice. Financial leverage mirrors the impact on returns of a change in the extent to which the firm's assets are financed with borrowed money. Financial leverage can be calculated with the help of the following formula:

FL= EBIT or OP/ EBT or PBT

Where,

FL = Financial leverage

OP = Operating profit (EBIT)

PBT = Profit before tax

The degree of financial leverage (DFL) measures a percentage change of earnings per share for each unit's change in EBIT that result from a company's changes in its capital structure. Earnings per share become more volatile when the degree of financial leverage is higher. The degree of financial leverage (DFL) is calculated as follows:

Degree of Financial Leverage = % Change in EPS / % Change in EBIT

This measure of degree of financial leverage DFL is affected by the initial earnings EBIT. This measure of financial leverage is not suitable to compare companies whose initial profits and earnings that are most certainly different, and it is also inadequate for comparisons over time for the same company. Financial leverage expands earnings per share and returns because interest is a fixed cost. When a company's revenues and profits are on the rise, this leverage works very favourably for the company and for investors. Nevertheless, when profits are pressured or falling, the exponential effects of leverage can become challenging.

 Uses of Financial Leverage:

Financial leverage helps to examine the relationship between EBIT and EPS. Financial leverage measures the percentage of change in taxable income to the percentage change in EBIT. Financial leverage pinpoints the correct profitable financial decision regarding capital structure of the company. Financial leverage is vital devices which is used to measure the fixed cost proportion with the total capital of the company. If the firm obtains fixed cost funds at a higher cost, then the earnings from those assets, the earning per share and return on equity capital will decrease.

Combined or Composite leverage:

When the company utilizes both financial and operating leverage to amplification of any change in sales into a larger relative changes in earning per share. Combined leverage is also known as composite leverage or total leverage. Combined leverage shows 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= Contribution or ‘C’ /EBT or PBT

                 Or

CL = OL  *   FL

Where,

CL = Combined Leverage

OL = Operating Leverage

FL = Financial Leverage

C = Contribution

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.

 Degree of Combined leverage = % Change in EPS/% Change in Sales

To summarize, Operating leverage is the degree to which a firm's fixed production costs contribute to its total operating costs at different levels of sales. In a firm that has operating leverage, a given change in sales results in major change in the net operating revenue. Financial leverage calculates the sensitivity of the firm's net income to changes in its net operating income (NOI). On the contrary to operating leverage, which is determined by the firm's choice of technology (fixed and variable costs), financial leverage is dogged by the firm's financing selections (the mix of debt and equity).

Examples:

    Question 1: 

    Sales: Rs. 50,000/-

    Variable Cost: Rs. 25,000/-

    Fixed Cost: Rs. 15,000/-

    Interest Charges: Rs. 5,000/-

   Operating Leverage, Financial Leverage and Combined Leverage will be:

   Operating leverage: Contribution /EBIT

   = Sales – Variable Cost/Sales – Variable Cost – Fixed Cost

   = (50,000 – 25,000)/(50,000- 25,000 – 15,000)= 2.5

   Financial Leverage= EBIT/EBIT-Interest

   = (50,000- 25,000 – 15,000)/ (50,000- 25,000 – 15,000 – 5,000) = 2

   Combined Leverage= Operating leverage x Financial Leverage

  = 2.5 x 2 = 5

Question 2:

Sales of a firm: Rs.10,00,000

Variable Cost: Rs. 7,00,000/-

Fixed Cost: Rs. 2,00,000/-

10% Debt: Rs. 5,00,000/-

Operating, Financial and Combined Leverage will be:

Operating leverage: Contribution /EBIT

= Sales – Variable Cost/Sales – Variable Cost – Fixed Cost

=10,00,000 – 7,00,000/10,00,000 – 7,00,000- 2,00,000=3

Financial Leverage= EBIT/EBIT-Interest

= 1,00,000/1,00,000-50,000=2

Combined leverage= Operating leverage x Financial Leverage

=3 x 2= 6

Question 3.

The capital Structure of a company is as under:

12% Debt: Rs. 100 Crores

Equity share Capital: Rs. 100 Crores

(10,00,000 shares @10/- each)

9% Preference Share Capital: Rs. 100 Crores

Tax Rate: 35%

The financial Break-Even Point will be:

Financial Break-Even point is that level of EBIT at which EPS is zero. It is equal to the Company’s Interest + Preference Dividend but before Taxes.

Financial Break-Even Point = (Interest) + (Preference Dividend/1-t)

= (12 crores) + (9 crores/1-.35) = Rs. 25.85 crores