LEVERAGE ANALYSIS  

 
Meaning - Leverage is the relationship between two integrated variables. In financial management leverage reflects the responsiveness or influences of one financial variable over and other.

Classification of Leverages
(1) Operating Leverage - It measures the relationship between sales volume and EBIT.
-          Degrees of Operating Leverage = Contribution / EBIT
-          Interpretation = % of Change in EBIT / % of Change in sales
             
Pro. 1 - Sales 1000 units @ Rs.10 per unit, variable cost Rs.4 per unit, Fixed cost Rs. 2,000.
(a) Calculate the Operating Leverage and interpret the result? (b) If the sales are increased or decreased by 40%, what will be the increase or decrease in EBIT?

Solution- (a) Calculation of Operating Leverage and Interpretation of result
Particulars
Amount
Sales (1000 x 10)
(-) Variable cost (1000 x 4)
10,000
  (4,000)
Contribution
(-) Fixed cost
  6,000
  (2,000)
Earnings Before Interest and Tax (EBIT)
  4,000
-          Degree of Operating Leverage (DOL) = C /EBIT = 6000/4000 = 1.5 (or) 1.5/1
-          Interpretation = % of Change in EBIT / %  of Change in Sales = 1.5% / 1%
-          The change in 1% in sales will result in 1.5% of change in EBIT.

(b) Increase / Increase in EBIT, if  Sales increase / decrease by 40%
Particulars
Increased by 40%
Decreased by 40%
Sales (10,000 x 140%)
(10,000 x 60%)
(-) Variable cost
(4,000 x 140%)
(4,000 x 60%)
14,000


(5,600)

6,000


(2,400)
Contribution
(-) Fixed cost (no change)
  8,400
  (2,000)
3,600
(2,000)
EBIT
  6,400
1,600
DOL
8400/6400 = 1.31%
3600/1600 = 2.25%
Interpretation
1.31 / 1
2.25 / 1
Note
-          Operating Leverage arises due to the existence of fixed cost in cost structure.
-          A firm having high Degree of Operating Leverage (DOL) can experience a substantial change in sub-standard firm
-          A small drop in sales will drastically reduce EBIT. Therefore a firm should avoid under high DOL.
-          Since it is a high risk situation, since small decrease in sales will reduce the profit substantially.
-          Therefore a firm should try to operate at level substantially higher than the chances of loss, when sales are minimized.

(b) Financial Leverage - It measures the relationship between EBIT and EPS.
-          Degree of Financial Leverage(DFL) –
o   when there is no preferential dividend = EBIT / EBT
o   When there is preferential dividend = EBIT / EBT – [Pref dividend / 1 – tax]
-          Interpretation = % of changes in EPS / % in changes of EBIT

Pro. 2 - EBIT is Rs. 2,000, Interest Rs. 1,000, Tax rate 50%, No of Equity share = 100.
(a) Calculate the Financial Leverage; (b) Find the value of EPS; (c) What will be the EPS, if EBIT increases by 50%?

Solution          Income Statement
Particulars
Amount
EBIT
(-) Interest
2,000
(1,000)
EBT
(-) Tax @ 50%
1,000
 (500)
EAT
 500





  

      (a)    Financial Leverage = EBIT / EBT = 1,000/500 = 2
      (b)   No of Equity shares = 100 shares
-          EPS = EAT / No. of Equity shares = 500 / 100 = Rs. 5 per share
-          DLF = [when there is no pref. dividend] = EBIT /EBT = 2000 / 1000 = 2 / 1
-          Interpretation -  % of changes in EPS / % of change in EBIT = 2 / 1
-          1% change in EBIT will result in 2% change in EPS.
       (c)    Assume EBIT is increased by 50%:
EBIT is increased by 50%, then EPS increased by double = 50 x 2 = 100%
and so, EPS will increase from Rs.5 to Rs.10
Note
-          Financial Leverage arises due to the existence of debt with the capital structure.
-          Debt financing is suggested only when the firm has prospects for Financial Leverage.
-          For this the cost of debt is to be compared with the ROI.
-          Favorable Financial Leverage will arise when the ROI is more than the Cost of Debt.
-          The high Financial Leverage brings in high return to shareholders at the same time exposing the company to high risk.

(c) Combined Leverage - Operating Leverage explains the business risk to shareholders and the Financial Leverage indicates the financial risk of the firm. The total risk of the firm that is business + financial risk is combined by Combined Leverage (CL).
-          Degree of Combined leverage (DCL) = DOL  x DFL
o   DCL, when there is no preference dividend = Contribution / EBT
o   DCL, when there is preference dividend = Contribution / EBT – [Pref dividend / 1 – Tax]
-          Interpretation - % of Changes in EPS / % of Changes in sales.

Pro. 3 - From the following details, calculate Leverages and interpret the results.
Particulars
A
B
C
Output(units)
60,000
15,000
1,00,000
Selling price per unit (Rs)
1
3
.50
Fixed cost (Rs)
7,000
14,000
15,000
Variable cost per unit (Rs)
.20
1.50
.02
Interest (Rs)
4,000
8,000
10,000
Preference Dividend
-
-
5,000
Tax rate
50%
50%
50%

Solution          Income Statement
Particulars
A (Rs)
B (Rs)
C (Rs)
Sales (unit x selling price)
(-) Variable cost (units x v c p u)
60,000
12,000
45,000
22,500
50,000
  2,000
Contribution
(-) Fixed cost
48,000
   7,000
22,500
14,000
48,000
15,000
EBIT
(-) Interest
41,000
  4,000
  8,500
  8,000
33,000
10,000
EBT
(-) Tax @ 50%
37,000
18,500
     500
     250
23,000
11,500
EAT
(-) Pref. Dividend
18,500
     -
     250
       -
11,500
  5,000
Amount Available to share holders
18,500
250
  6,500

Solution – Computation of Leverages
Particulars
A
B
C
Operating Leverage
= C / EBIT
48,000/41,000
= 1.17  
22,500/8,500
= 2.65   
48,000/33,000
= 1.45
Financial Leverage
= EBIT/EBT-[Pref.divi/1-tax]   
41,000 / 37,000
= 1.11
8,500 / 500
= 17
33000/ 23000-[5000/1-.50] = 2.54
Combined Leverage
= DOL  x DFL
1.17 x 1.11 = 1.30
2.65 x 17 = 45.05
1.45 x 2.54 = 3.69

Pro. 4 - A firm has sales of Rs.10,00,000; variable cost Rs.7,00,000; Fixed cost Rs.2,00,000. It has a debt of Rs.5,00,000 (10%). (a) Calculate Leverages?
                             (       i)            If the firm wants to double the EBIT, what % would the sales changes?
                                         (ii)            If the sales increase by 20%, by what % the EPS will be changed?
                                         (iii)            If the firm wants to double the EPS, what % would the EBIT changed? 
Solution                      Income Statement
Particulars
Amount (Rs)
 Sales
(-) Variable Cost
10,00,000
  7,00,000
Contribution
(-) Fixed cost
  3,00,000
  2,00,000
EBIT
(-) Interest (5,00,000  x 10%)
  1,00,000
     50,000
EBT
(-) Tax
     50,000
          -
Earnings to Shareholders
     50,000
                       





              




     

       (a)   Calculation of Leverages
-          Operating Leverage = Contribution / EBIT = 3,00,000 / 1,00,000 =3 / 1
-          Financial Leverage = EBIT / EBT = 1,00,000 / 50,000 = 2 / 1
-          Combined Leverage = OL x FL = 3 x 2 = 6 (or) C / EBT = 3,00,000 / 50,000 = 6

          (i)     If the firm wants to double the EBIT, what % would the sales changes?
-          Interpretation of Operating Leverage = Change in EBIT / Change in sales = 3/ 1;
-          If sales is 1%, EBIT will be 3%; If EBIT is 100%, then Sales will be
o   100% x 3 / 1 = 33 1/3% or 33.33%; So, Sales will be 33.33%

(ii)          If the sales increase by 20%, by what % the EPS will be changed?
-          Combined Leverage interpretation = % of change in EPS / % change in sales = 6/1;
-          If sales is 1%, EPS will be 6%; If Sales is 20%, then EPS will be
o   20 x 6/1 = 120%; So, EPS will be increased by 120%.

(iii)        If the firm wants to double the EPS, what % would the EBIT changed?
-          Financial Leverage interpretation = % change in EPS / % change in EBIT = 2/1
-          If EBIT is 1%, EPS will be 2%; If EPS is 100%, then EBIT will be
o   100 x 1/2 = 50%; So, Change in EBIT will be 50%.

Pro. 5 Variable expenses as a percentage of sales is 75%; interest Rs.300; Operating Leverage = 6; Financial Leverage = 4; tax rate = 50%. Prepare Income Statement?

Solution          Income Statement
Particulars
Amount (Rs)
Sales
(-) Variable Cost
9,600
7,200
Contribution
(-) Fixed Cost
2,400
2,000
EBIT
(-) Interest (given)
    400
    300
EBT
(-) Tax (50%)
    100
      50
EAT
      50
              










Working Note
(i)                 To find EBIT and EBT
-          Financial leverage = EBIT / EBT = 4/ 1
-          That is EBIT – EBT = Interest (or) 4 -1 = 3
-          If 3 represents Rs.300, 4 would represent 400, which is EBIT
-          Then  1 will be 100, which is EBT
-          So, EBIT = Rs.400; EBT = Rs.100. 

(ii)               To find Contribution and Fixed Cost
-          Operating Leverage = Contribution / EBIT =6 / 1
-          1 time of EBIT represents Rs. 400;
-          So, 6 times will represent = 6 x 400 = Rs.2,400, which is Contribution
-          To find, Fixed Cost
o   EBIT = Contribution – Fixed Cost
o   (or) Fixed Cost  = Contribution - EBIT
o   Fixed Cost = 2,400 – 400 = 2,000

(iii)             To find Sales and Variable Cost
-          Sales – Variable Cost = Contribution
-          If Sales is 100 and Variable Cost is 75, then Contribution = 100 -75 = 25
-          If 25 of Contribution is Rs. 2,400, then Sales will be 100 of Contribution;
-          That is, 2,400 x 100/25 = Rs. 9,600, which is Sales
-          and Variable Cost will be 75 of Sales, ie, 9,600 x 75/100 = Rs. 7,200

Pro. 6 Operating Leverage = 2; Combined Leverage = 3; At present sale level of 10,000 units; selling price = Rs.12; variable cost = 50% of sales; Tax Rate = 50%, the Co. has no of preference share capital. If the rate of interest of the company’s debt is 16 %, calculate the amount of debt to the capital structure?

 Solution                                   Income Statement
Particulars
Amount (Rs)
          Sales (10,000 x 12)
(-) Variable Cost (50% of sales)
1,20,000
   60,000
Contribution
(-) Fixed cost
   60,000
   30,000
EBIT
(-) Interest
   30,000
   10,000
EBT
(-) Tax @ 50%
   20,000
   10,000
EAT
   10,000
                  












(i)                 Operating Leverage  = Contribution / EBIT = 2 / 1        
-          2 times Contribution = 60,000; So, 1 time EBIT =?  
-          EBIT = 60000 x 1/2 = 30,000
(ii)               Combined Leverage = Contribution / EBT = 3 / 1          
-          3 time Contribution = 60,000; So, 1 EBT =? 
-          EBT = 60000 x 1/3 = 20,000
-          Debt -  16% = 10000             
-          10,000 x 100/16 = Rs. 62,500