LEVERAGES

Definition:

The dictionary meaning of the firm leverages refers to an increase means of accomplishing purpose. Leverage is a general term for any technique to multiply gains and losses. Common ways to attain leverage are borrowing money and buying fixed assets Likewise in business, leverage refers to the use of a relatively small investment or a small amount of debt to achieve greater profits. That is, leverage is the use of assets and liabilities to boost profits while balancing the risks involved.

 The employment of an asset or funds for which the firm pays the fixed costs or a fixed returns - James Horne

Types of Leverages:
Activity leverage: Operating leverage Financial leverage Combined leveraged Structure leverage: Equity Debt + Equity

1. Operating Leverages: The employment of an asset with a fixed cost in the hope that sufficient revenue may be generated to cover all the fixed and variable costs. The operating leverage is a measure of how revenue growth translates into growth in operating income. It is a measure of leverage, and of how risky (volatile) a company's operating income is.

Formulae: Operating Leverage = Contribution EBIT Operating leverage is directly proportional to business risk.

Degree of Operating Leverage: The sensitivity of EBIT to changes in unit sales is referred to as the degree of operating leverage. Degree of Operating Leverage = % Change in EBIT % Change in Sales

Implications of Operating Leverage:

High degree of operating leverage reflects a small change in sales will have large effect on operating income. Fixed Operating cost magnify the impact of changes in sales. Low operating leverage is considered to be an ideal situation for the maximization of profits with minimum risks.

2. Financial Leverages: It can be defined as the use of funds with a fixed cost in order to increase earning per share of the company According to Gitman Financial Leverage is the ability of the firm to use fixed financial charges to magnify the effects of changes in Earnings before Interest & Taxes (EBIT) on the companys Earning Per Share (EPS). Formulae: Financial Leverage = EBIT EBT

Degree of Financial Leverage:

The sensitivity of profit before tax to changes in Earnings before Interest & Taxes (EBIT) is referred to as the degree of financial leverage.

DFL = % Change in EPS % Change in EBIT

Implications of Financial Leverage: One percent change in Earnings before Interest & Taxes (EBIT) leads to more than one percent change in Earning before Tax (EBT) or Earning Per Share (EPS) Financial Leverages focuses the attention on the Market Price of the share.

Low financial leverage is considered to be an ideal situation for the maximization of the profits with minimum of risk.

3. Combined Leverages: The potential use of fixed costs, both operating and financial which magnifies the effect of sales volume on EPS of the company. It expresses the relationship between revenue on account of sales and taxable income.

Formulae : Combine leverage = Contribution EBT

Degree of combined leverage:

The sensitivity of earning per share to changes in unit sales is referred to as the degree of combined leverage.
DCL = % change in EPS % change in Sales

Implications of combined leverage :

Financial or operating leverages exists only when the result of the calculation is more than one .
A company with high operating leverage should have low financial leverage so that the combined leverage may be ideal A company having low operating leverage will stand to gain by having a high financial leverage provided it has enough profitable opportunities for the employment of borrowed funds

Significance of leverage :

1. Used as a tool to measure the return to the owners. 2. Maintain balance between two leverages. 3. High leverages makes firm more risk. 4. Low operating and financial leverages is considered ideal for maximization of profits with minimum risk.

Capital Structure

Capital Structure refers to the combination or mix of debt and equity which a company uses to finance its long term operations.

Raising of capital from different sources and their use in different assets by a company is made on the basis of certain principles that provide a system of capital so that the maximum rate of return can be earned at a minimum cost. This sort of system of capital is known as capital structure.

Total Required Capital

From Shares
Equity Share capital Preference Share Capital

From Debentures

Optimal Capital Structure: That capital structure (mix of debt, preferred, and common equity) at which P0 is maximized. ROE and EPS against higher risk. The tax-related benefits of leverage are exactly offset by the debts risk-related costs. The target capital structure is the mix of debt, and common equity with which the firm intends to raise capital.