leverage
A company uses different sources of financing to fund its activities. •These sources can be classified as those which carry a fixed rate of return and those whose returns vary. •Leverage is the influence of power to achieve something. •The use of an asset or source of funds for which the company has to pay a fixed cost or fixed return is termed as leverage. •Leverage is the influence of an independent financial variable on a dependent variable. •It studies how the dependent variable responds to a particular change in independent variable.
Operating Leverage
Operating leverage arises due to the presence of fixed operating expenses in the firm’s income flows.
•A company’s operating costs can be categorised into three main sections as shown below: operating cost----1.fixed cost
2.variable cost
3.semi variable cost
•Fixed costs are those which do not vary with an increase in production or sales activities for a particular period of time.
•Variable costs are those which vary in direct proportion to output and sales.
•Semi-variable costs are those which are partly fixed and partly variable in nature.
When a firm has fixed operating expenses, an increase in sales results in a more proportionate increase in earnings before interest and taxes (EBIT) and vice versa.
•The former is a favourable operating leverage and the latter is unfavourable.
•Degree of operating leverage (DOL) examines the effect of the change in the quantity produced on earnings before interest and taxes (EBIT).
DOL = % change in EBIT / % change in output
Or (ΔEBIT/EBIT) / (ΔQ/Q)
EBIT = Q(S—V)—F
Where Q is quantity, S is sales, V is variable cost , F is fixed cost
•Substituting this we get, DOL = {Q(S—V)} / {Q(S—V)—F}
Application of Operating Leverage
•As operating leverage can be favourable or unfavourable; high risks are attached to higher degrees of leverage.
•The applications of operating leverage are as follows:
–Business risk measurement : A business risk is measured using the degree of operating leverage (DOL)
Greater the DOL, more sensitive is the earnings before interest and tax (EBIT) to a given change in unit sales. A high DOL is a measure of high business risk and vice versa.
–Production planning : A change in production method increases or decreases DOL.
A firm can change its cost structure by mechanising its operations, thereby reducing its variable costs and increasing its fixed costs. This will have a positive impact on DOL.
Financial Leverage
•Financial leverage as opposed to operating leverage relates to the financing activities of a firm.
•It measures the effect of earnings before interest and tax (EBIT) on earnings per share (EPS) of the company.
•Financial leverage refers to the mix of debt and equity in the capital structure of the firm.
•It is the firm’s ability to use fixed financial charges to increase the effects of changes in EBIT on the EPS.
•A company earning more by the use of assets funded by fixed sources is said to be having a favourable or positive leverage.
•Unfavourable leverage occurs when the firm is not earning sufficiently to cover the cost of funds.
•Financial leverage is also referred to as “Trading on Equity”.
•The degree of financial leverage (DFL) is a more precise measurement.
•It examines the effect of the fixed sources of funds on EPS.
DFL = %change in EPS
%change in EBIT
DFL={ΔEPS/EPS} ÷ {ΔEBIT/EBIT}
Or DFL = EBIT ÷ {EBIT—I—{Dp/(1-T)}}
Where,
I is Interest
Dp is dividend on preference shares
T is tax rate
Use of Financial Leverage
•Studying the degree of financial leverage (DFL) at various levels makes financial decision-making, on the use of fixed sources of funds, for funding activities easy.
•One can assess the impact of change in earnings before interest and tax (EBIT) on earnings per share (EPS).
•The risks are high at high degrees of financial leverage (DFL). An increase in financial costs implies higher level of EBIT to meet the necessary financial commitments.
•Factors in relation to DFL should be considered while formulating the firm’s mix of sources of funds.
Impact of financial leverage
•Highly leveraged firms are considered very risky and lenders and creditors may refuse to lend them further to fuel their expansion activities.
•On being forced to continue lending, they may do so with their own conditions like earning a minimum of X% EBIT or stipulating higher interest rates than the market rates or no further mortgage of securities.
•Financial leverage is considered to be favourable till such time that the rate of return exceeds the rate of return obtained when no debt is used.
•The company not using debt to finance its assets has a higher DFL compared to that of a company using it.
•Financial leverage does not exist when there is no fixed charge financing.
Total or Combined Leverage
• The combination of operating and financial leverage is called combined leverage.
• Operating leverage affects the firm’s operating profit EBIT and financial leverage affects PAT or the EPS.
• The combined effect is quite significant for the earnings available to ordinary shareholders.
• Combined leverage is the product of degree of operating leverage (DOL) and degree of financial leverage (DFL).
• Degree of Total/ Combined Leverage (DTL) can be expressed as;
Uses of degree of total leverage (DTL)
•Degree of total leverage (DTL) measures the total risk of the company as DTL is a combined measure of both operating and financial risk.
•Degree of total leverage (DTL) measures the variability of EPS
A company uses different sources of financing to fund its activities. •These sources can be classified as those which carry a fixed rate of return and those whose returns vary. •Leverage is the influence of power to achieve something. •The use of an asset or source of funds for which the company has to pay a fixed cost or fixed return is termed as leverage. •Leverage is the influence of an independent financial variable on a dependent variable. •It studies how the dependent variable responds to a particular change in independent variable.
Operating Leverage
Operating leverage arises due to the presence of fixed operating expenses in the firm’s income flows.
•A company’s operating costs can be categorised into three main sections as shown below: operating cost----1.fixed cost
2.variable cost
3.semi variable cost
•Fixed costs are those which do not vary with an increase in production or sales activities for a particular period of time.
•Variable costs are those which vary in direct proportion to output and sales.
•Semi-variable costs are those which are partly fixed and partly variable in nature.
When a firm has fixed operating expenses, an increase in sales results in a more proportionate increase in earnings before interest and taxes (EBIT) and vice versa.
•The former is a favourable operating leverage and the latter is unfavourable.
•Degree of operating leverage (DOL) examines the effect of the change in the quantity produced on earnings before interest and taxes (EBIT).
DOL = % change in EBIT / % change in output
Or (ΔEBIT/EBIT) / (ΔQ/Q)
EBIT = Q(S—V)—F
Where Q is quantity, S is sales, V is variable cost , F is fixed cost
•Substituting this we get, DOL = {Q(S—V)} / {Q(S—V)—F}
Application of Operating Leverage
•As operating leverage can be favourable or unfavourable; high risks are attached to higher degrees of leverage.
•The applications of operating leverage are as follows:
–Business risk measurement : A business risk is measured using the degree of operating leverage (DOL)
Greater the DOL, more sensitive is the earnings before interest and tax (EBIT) to a given change in unit sales. A high DOL is a measure of high business risk and vice versa.
–Production planning : A change in production method increases or decreases DOL.
A firm can change its cost structure by mechanising its operations, thereby reducing its variable costs and increasing its fixed costs. This will have a positive impact on DOL.
Financial Leverage
•Financial leverage as opposed to operating leverage relates to the financing activities of a firm.
•It measures the effect of earnings before interest and tax (EBIT) on earnings per share (EPS) of the company.
•Financial leverage refers to the mix of debt and equity in the capital structure of the firm.
•It is the firm’s ability to use fixed financial charges to increase the effects of changes in EBIT on the EPS.
•A company earning more by the use of assets funded by fixed sources is said to be having a favourable or positive leverage.
•Unfavourable leverage occurs when the firm is not earning sufficiently to cover the cost of funds.
•Financial leverage is also referred to as “Trading on Equity”.
•The degree of financial leverage (DFL) is a more precise measurement.
•It examines the effect of the fixed sources of funds on EPS.
DFL = %change in EPS
%change in EBIT
DFL={ΔEPS/EPS} ÷ {ΔEBIT/EBIT}
Or DFL = EBIT ÷ {EBIT—I—{Dp/(1-T)}}
Where,
I is Interest
Dp is dividend on preference shares
T is tax rate
Use of Financial Leverage
•Studying the degree of financial leverage (DFL) at various levels makes financial decision-making, on the use of fixed sources of funds, for funding activities easy.
•One can assess the impact of change in earnings before interest and tax (EBIT) on earnings per share (EPS).
•The risks are high at high degrees of financial leverage (DFL). An increase in financial costs implies higher level of EBIT to meet the necessary financial commitments.
•Factors in relation to DFL should be considered while formulating the firm’s mix of sources of funds.
Impact of financial leverage
•Highly leveraged firms are considered very risky and lenders and creditors may refuse to lend them further to fuel their expansion activities.
•On being forced to continue lending, they may do so with their own conditions like earning a minimum of X% EBIT or stipulating higher interest rates than the market rates or no further mortgage of securities.
•Financial leverage is considered to be favourable till such time that the rate of return exceeds the rate of return obtained when no debt is used.
•The company not using debt to finance its assets has a higher DFL compared to that of a company using it.
•Financial leverage does not exist when there is no fixed charge financing.
Total or Combined Leverage
• The combination of operating and financial leverage is called combined leverage.
• Operating leverage affects the firm’s operating profit EBIT and financial leverage affects PAT or the EPS.
• The combined effect is quite significant for the earnings available to ordinary shareholders.
• Combined leverage is the product of degree of operating leverage (DOL) and degree of financial leverage (DFL).
• Degree of Total/ Combined Leverage (DTL) can be expressed as;
Uses of degree of total leverage (DTL)
•Degree of total leverage (DTL) measures the total risk of the company as DTL is a combined measure of both operating and financial risk.
•Degree of total leverage (DTL) measures the variability of EPS