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LESSON

21
LEVERAGE ANALYSIS
CONTENTS
21.0

Aims and Objectives

21.1

Introduction

21.2

Operating Leverage

21.3

Financial Leverage

21.4

EBIT-EPS Analysis

21.5

Combined Leverage

21.6

Let us Sum up

21.7

Lesson-end Activity

21.8

Keywords

21.9

Questions for Discussion

21.10 Suggested Readings

21.0 AIMS AND OBJECTIVES

The main objective of this lesson is to discuss about operation and financial leverages
and their impact. After studying this lesson you will be able to:
(i)

describe the concept of operating leverage and calculate the degree of operating
leverage

(ii)

explain various aspects of financial leverage

(iii) describe EBIT-EPS analysis to study the impact of the leverage

21.1 INTRODUCTION
Leverage means the fixed commitment of the organization. The fixed commitment of
the organization can be classified into two different categories viz fixed cost of operations
and fixed cost of servicing. The fixed cost of operations are pertaining to the investment
decisions and the fixed cost of servicing with reference to the financing decision.
Fixed cost of operations Investment decisions.
Fixed cost of servicing Financing decisions.
If Revenues are more than the Variable Cost and Fixed Cost, that is called favorable
or otherwise unfavorable.

21.2 OPERATING LEVERAGE

Operating Leverage is connected with the acquisition of assets where as the financial
Leverage is connected with the Financing of activities.

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Operating leverage: It is a relationship in between the Sales and Earnings before

interest and taxes.
Financial leverage: It is a relationship in between the Earnings before interest and
taxes and Earnings per share.
Operating and Financial: In the Operating and Financial leverages, the EBIT is found
as a common phenomenon. During the first part of the chapter, let us discuss about the
operating leverage. It emerges only due to Fixed operating expenses. By and large, the
expenses are classified into two categories viz Fixed and Variable in categories for the
analysis of leverage.
l

Operating Leverage is defined as the ability to use fixed operating costs to magnify
the effects of changes in sales on its earnings before interest and taxes.

Described as % change in profits accompanying the % change in volume.

"The firms' ability to use fixed operating costs to magnify the effects of changes in
the sales on its earnings before interest and taxes".

A firms sells products for Rs 100 per unit has variable operating costs of Rs. 50 per
unit and fixed operating cost of Rs. 50,000 per year. Show the various levels of
EBIT that would result from sale of i) 1000 units ii) 2000 units iii) 3000 units.
Case B

Base

Case A

Level from the base

50%

Sales in units

1,000

2,000

3,000

+50%

Sales volume in Rs

1,00,000

2,00,000

3,00,000

Variable cost

50,000

1,00,000

1,50,000

Contribution

50,000

1,00,000

1,50,000

Fixed cost

50,000

50,000

50,000

Profit

Zero

50,000

100%

1,00,000
+100%

From the above illustration, it is obviously understood that from the two different cases.
Case A illustrates that 50% increase in the volume of sales led to 100% increase in the
volume of profit.
Case B highlights that 50% reduction in the volume of sales led to 100% decrease in the
volume of profit.
It is clearly evidenced that % change in the volume of sales is less than the % change in
the volume of profit.
The next step is to define the Degree of Operating Leverage (DOL)
l

DOL is the measure reveals the extent or degree of operating leverage.

When Operating leverage exists ?

Proportionate change in EBIT of a given change in sales is greater than the Proportionate
in sales

DOL =

Percentage change in EBIT

Percentage change in Sales

Case A= 100%/50%= =+2

Case B=(100%)/(50%)=+2
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By algebraically proven and the following formula has derived to determine the DOL
through the alternate methodology

DOL =

Leverage Analysis

Total Contribution (Base Level)

EBIT ( Base Level)

To determine the degree of the operating leverage, from the above illustration which is
applied
DOL= Rs.1,00,000/Rs.50,000= +2
The answer of the DOL has been checked in both directions to the direct methodology.
If there is no fixed operating cost in the manufacturing enterprise ? What would be the
Degree of Operating leverage ?
Particulars

Base Level

New Level

Units sold

1,000

1,100

Sales price per unit

Rs.10

Rs.10

Variable cost per unit

Fixed operating cost

Nil

Nil

Calculate the Degree of operating leverage

DOL =

Total contribution
EBIT

To find out the EBIT = Sales -VC=Contribution i.e. EBIT

DOL =

R400
= +1
Rs.400

In the alternate methodology, the DOL is as follows:

DOL =

% change in EBIT 10%

=
= +1
% change in Sales
10

When there is no fixed cost in the cost of operations means that the firm does not have
operating leverage in its operations.
The operating leverage is related to the operating risk of the investments, which means
that fixed cost of operations of the enterprise. It highlights that greater the fixed cost of
operations means that higher the operating risk; which means that greater will be break
even point and vice versa. The greater volume of fixed cost of operations are found to
be more favorable only during the occasion of greater volume of earnings, unless otherwise
the dominance of fixed cost of operations are found to be undesirable to magnify the
volume of EBIT.

21.3 FINANCIAL LEVERAGE

The next leverage is Financial Leverage which arises due to servicing of financial
resources.
l

It results from the presence of fixed financial charges in the firms. The fixed
financial charges are nothing but the preference dividend and interest on the fixed
charge financial resources.

Financial leverage, how the fixed charge financial resources influence the EBIT
of the firm and finally provides earnings to the shareholders. It reveals the ability

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of the firm to make use of "fixed financial charges to magnify the effects of changes
in EBIT on the earnings per share".
The other name of the financial leverage is Trading on Equity, which illustrates the
relationship in between the application of the fixed charge of funds in the capital structure
and Earning per share. It is the leverage analysis highlights the relationship in between
the financing decision and investment decision.
The fixed financial charge should pave way for the firm to not only to earn the greater
EBIT but also to magnify the EPS of the shareholders.
l

The financial manager of the hypothetical ltd expects that its earnings before
interest and taxes (EBIT) in the current year would amount to Rs.10,000. The
firm has 5 percent bonds aggregating Rs.40,000 while the 10 percent preference
shares amount to Rs. 20,000 what should be the earnings per share (EPS)?
Assuming the EBIT being i) Rs.6,000 Rs.14,000. How EPS is affected ? The firm
tax bracket 35%. Ordinary number of shares 1,000
Level from the base
EBIT
Interest
Earnings Before Interest
Taxes 35%
EAT
Preference dividend
Earnings to share holders
EPS
Level

Case 2
40%
6,000
2,000
4,000
1,400
2,600
2,000
600
.6
81.25%

Base
10,000
2,000
8,000
2,800
5,200
2,000
3,200
3.2

Case 1
+40%
14,000
2,000
12,000
4,200
7,800
2,000
5,800
5.8
81.25%

From the above illustration, 40% increase in the level of EBIT posed 81.25% increase in
the EPS and vice versa.
Financial leverage can be quantified through the Degree of Financial Leverage (DFL)
The degree of financial leverage is defined as the ratio of % change in the EPS and %
change in the EBIT. Which always greater than 1. The degree of financial leverage is
more than one due to presence of fixed charge of financial resources. This profound
relationship is algebraically proven and illustrated that

DFL (Base) =

EBIT
EBITIDp/1t

DFL of the above firm is as follows:

DFL =

% change in EPS
81.25%
=
= 2.03125
% Change in EBIT
40%

Alternately, the DFL is computed as follows through the following methodology

DFL =

Rs. 10,000
Rs10,000 Rs.2,000Rs.2,000/.65

= 2.03125
The same example drawn for our better understanding by excluding the fixed charge of
financial resources
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Leverage Analysis

Case B

Case A

Level of Change

40%

+ 40%

EBIT

6,000

10,000

14,000

Taxes 35%

2,100

3,500

4,900

EAT

3,900

6,500

9,100

Earnings to share holders

3,900

6,500

9,100

EPS

3.9

6.5

9.1

Degree of financial leverage =

Case A =

+ 40%
=+1
+40%

Case B =

40%
=+1
40%

% change in EPS
% Change in EBIT

Alternately, the DFL could be found out as follows:

=

Rs.10,000
= +1
Rs.10,00000

It means that the higher Degree of financial leverage means that greater the financial
risk of the firm and vice versa. The greater degree of financial leverage is favorable
only during the greater volume of EBIT to meet the fixed charges unless otherwise, the
firm is required to undergo for liquidation. The interest of the firm may be brought under
the control of the debenture holders and preference shareholders.

21.4 EBIT-EPS ANALYSIS

It is an analysis to study the impact /effect of the leverage. This could be studied through
comparison of various financing plans of EBIT.
(i)

Exclusive use of debt

(ii)

Exclusive use of Equity shares

(iii) Exclusive use of Preference shares

(iv) Combination of (i), (ii) & (iii)
(v)

Combination of (i) & (ii)

(vi) Combination of (ii) & (iii)

(vii) Combination of (i) & (iii)
Among the various plans, we have to identify the best plan which has highest EPS over
the others.
The firm which has highest EPS normally has least volume of fixed financial charge
over the other firms.
What is meant by financial break even point ?
It is the level of EBIT to meet the fixed financial charge of the firm viz Interest on long
term borrowings/Debentures and Preference dividend on Preference shares.
The following formula is used to compute the financial break even point for the firm to
earn at least to cover the fixed financial charges of the firm:

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Financial break even point= I + PD/1t

The next analysis is nothing but Indifference point.
Indifference Point:
It is the point at which the EPS and EBIT are nothing but the same for two different
financing plans known as the indifference point.
The indifference point could be found out through the following analyses:
(i)

Algebraic approach

(ii)

Graphic approach

The measures of the Financial leverage:

They are two in categories:
(i)

Stock terms

(ii)

Flow terms

Stock Terms: The following are the two ratios viz debt equity ratio and debt + preference
share capital to total capitalization ratio to measure the financial leverage.
Flow terms: The financial leverage means debt service ration and preference dividend
coverage ratio to measure the capacity of the firm in meeting the periodical fixed financial
commitments of the firm.

21.5 COMBINED LEVERAGE

It is the combination of both leverage viz Operating leverage and financial leverage. The
combination means that the product of both leverages viz operating risk and financial
risk, which facilitates to determine the total risk of the firm.
DCL= DOL XDFL

DCL =

% change in EPS
% change in Sales

The combined leverage is nothing but % change in the sales volume of the firm leads to
certain % change in the EPS.
DCL = Contribution/EBITI
Check Your Progress
1.

Elucidate the Degree of Financial leverage.

2.

Explain the detailed process of EBIT-EPS analysis.

21.6 LET US SUM UP

296

Leverage means the fixed commitment of the organization. The fixed commitment of
the organization can be classified into two different categories viz fixed cost of operations
and fixed cost of servicing. Operating leverage is a relationship in between the Sales
and Earnings before interest and taxes. Financial leverage is a relationship in between
the Earnings before interest and taxes and Earnings per share. The operating leverage is
related to the operating risk of the investments, which means that fixed cost of operations
of the enterprise. It highlights that greater the fixed cost of operations means that higher
the operating risk; which means that greater will be break even point and vice versa.

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The greater volume of fixed cost of operations are found to be more favorable only
during the occasion of greater volume of earnings, unless otherwise the dominance of
fixed cost of operations are found to be undesirable to magnify the volume of EBIT. The
other name of the financial leverage is Trading on Equity, which illustrates the relationship
in between the application of the fixed charge of funds in the capital structure and
Earning per share. It is the leverage analysis highlights the relationship in between the
financing decision and investment decision. EBIT-EPS analysis is an analysis to study
the impact /effect of the leverage.

Leverage Analysis

21.7 LESSON-END ACTIVITY

Discuss the role of EBIT-EPS analysis in studying the effect of leverage.

21.8 KEYWORDS
Leverage: Fixed commitments of the firm
Operating leverage: It is a measure in the expression of business risk through
quantification of fixed cost
Financial leverage: It is an expression of financial risk due to the presence of fixed
financial commitment of the firm
Combined leverage: Combination of both leverages i.e. Product of Operating and
Financial leverages
Financial break even point: It is a level of EBIT to cover the fixed financial commitment
of the firm
Indifference point: It is the point at which the EBIT and EPS level of the two different
financing plans are nothing but the same.

21.9 QUESTIONS FOR DISCUSSION

1.

What is leverage ?

2.

Classify the type of leverages.

3.

Define operating leverage.

4.

Explain the Degree of operating leverage.

5.

Define the financial leverage.

6.

Describe the combined leverage.

7.

Define Indifference point.

8.

Define Financial break even point.

21.10 SUGGESTED READINGS

R.L. Gupta and Radhaswamy, Advanced Accountancy.
V.K. Goyal, Financial Accounting, Excel Books, New Delhi.
Khan and Jain, Management Accounting.
S.N. Maheswari, Management Accounting.
S. Bhat, Financial Management, Excel Books, New Delhi.
Prasanna Chandra, Financial Management Theory and Practice, Tata McGraw
Hill, New Delhi (1994).
I.M. Pandey, Financial Management, Vikas Publishing, New Delhi.
Nitin Balwani, Accounting & Finance for Managers, Excel Books, New Delhi.

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