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7/27/2019 Leverages_abhishek.docx
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Leverages
Financial Leverage and Operating Leverage
Abhishek Agarwal, Application Id: 60833
ABSTRACT
This Assignment explains the concept of Financial And Operating
Leverages, as I understand it.
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Financial Leverage and Operating Leverage
Leverage is generally defined as the ratio of the percentage change in profits to the
percentage change in sales. In other words, leverage is the multiplying effect thatfixed costs have on profits when there is any change in sales. As sales increases or
decreases, it is only the variable costs that change correspondingly, fixed costs remain
constant. Profits therefore increase or decrease at a faster rate than the rate of change
in sales. This can be better understood with an example.
A hypothetical income statement for a firm is as follows:
Sales 2000
Less: Variable costs 800
------
Contribution 1200
Less: Fixed costs 500
------
Profits 700
------
If the sales of this firm are increased by 20%, the income statement will stand revised
as follows:
Sales 2500 (increase of 25%)
Less: Variable costs 1000 (increase of 25%)
------
Contribution 1500 (increase of 25%)
Less: Fixed costs 500 (No change)
--------
Profits 1000
---------
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With an increase in sales of 25% from Rs. 2,000 to Rs. 2,500, profits have increased
from Rs. 700 to Rs. 1000, an increase of 43%. This is the effect of leverage. If the
firm had no fixed costs at all but all its costs were variable, there would have been no
leverage and the percentage change in sales would have been the same as the
percentage change in profits. It is fixed costs that introduce leverage into the firm and
higher the fixed cost, higher is the leverage.
You can think of leverage as shorthand for your business's ability to get funding.
Higher equity creates increased leverage and vice-versa. If your business is fully
leveraged, it won't be able to borrow money.
Leverage tells us how we can know from our sales that how much EBIT (earnings
before interest and taxes) will be. In accounting it is called degree of leverage and is
calculated as:
DOL= Contribution Margin/EBIT
For exp: if DOL=2 It means if we increase sale by 5% EBIT will increase by 10%.
A firm with no fixed financing costs has no financial leverage. In such a firm,
earnings per share will rise and fall with EBIT by the same percentage. For example,
a 15% increase in EBIT will result in a 15% increase in EPS; a 9% decrease in EBIT
will result in a 9% decrease in EPS.
A firm with some fixed financing costs does have financial leverage. In such a firm,
earnings per share will rise and fall with EBIT by a greater percentage. For example,
a 15% increase in EBIT will result in a more-than-15% increase in EPS; a 9%
decrease in EBIT will result in a more-than-9% decrease in EPS.
There are two types of Leverages:
A. Financial Leverage
B. Operating Leverage
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Financial Leverage: Financial leverage is the extent to which debt (liability) is used in
the Capital Structure (financing) of the firm. Capital Structure refers to the
relationship between assets, debt (liability) and equity. The more debt a firm has
relative to equity the greater the financial leverage (these firms have a higher Debt to
Asset ratios).
Formula:
Operating Leverage: Operating leverage is a measure of the extent to which, fixed
operating costs are being used in an organization. It is greatest (largest) in companies
that have a high proportion of fixed operating costs in relation (proportion) to variable
operating costs. This type of company is using more fixed assets in the operation of
the company. Firms with large amounts of fixed operating costs have high break-even
points and high operating leverage. Variable cost in these firms tends to be low and
both the contribution(CM) and unit contribution (UC) margin is high.
Formula-
Conclusion:
Both operating and financial leverage result in the magnification of changes to
earnings due to the presence of fixed costs in a company's cost structure. The
Contribution
Operating leverage = ----------------
PBIT
PBIT
Financial Leverage = ----------
PBT
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difference is only the part of the income statement we are looking at. Operating
leverage is the magnification on the top half of the income statement - how EBIT
changes in response to changes in sales; the relevant fixed cost is the fixed cost of
operating the business. Financial leverage is the magnification on the bottom half of
the income statement - how earnings per share changes in response to changes in
EBIT; the relevant fixed cost is the fixed cost of financing, in particular interest.
Choice over operating leverage depends on the technologies available to a company.
Some companies have little control over their operating leverage. For example,
airlines which have no substitute for airplanes and their associated support systems
can only operate with a large investment in fixed assets that create fixed costs. Other
companies have a significant degree of control over their operating leverage. Many
manufacturing companies, for example, can choose to produce using automated
equipment or piecework labor. By contrast, most firms have total control over their
financial leverage through their choice of financing (the exception is small firms that
have limited access to financial markets, hence limited financing alternatives). A
company can increase its financial leverage by using debt financing and can avoid
financial leverage through financing with equity.