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    Leverage

    Uploaded by

    Chiranjeev Routray
    The document discusses operating leverage and financial leverage. It provides a comparison chart that outlines the key differences between the two types of leverage. Operating leverage is defined as a firm's use of fixed costs in operations to generate returns, while financial leverage refers to a firm's use of debt in its capital structure that requires interest payments. The degree of operating leverage measures the impact on EBIT from sales changes, while the degree of financial leverage measures the impact on EPS from EBIT changes. A low degree of operating leverage is generally preferred to reduce business risk, while a high degree of financial leverage is preferred when the return on capital employed exceeds the cost of debt.

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    Leverage

    Uploaded by

    Chiranjeev Routray
    244 views7 pages
    The document discusses operating leverage and financial leverage. It provides a comparison chart that outlines the key differences between the two types of leverage. Operating leverage is defined as a firm's use of fixed costs in operations to generate returns, while financial leverage refers to a firm's use of debt in its capital structure that requires interest payments. The degree of operating leverage measures the impact on EBIT from sales changes, while the degree of financial leverage measures the impact on EPS from EBIT changes. A low degree of operating leverage is generally preferred to reduce business risk, while a high degree of financial leverage is preferred when the return on capital employed exceeds the cost of debt.

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    leverage

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    The document discusses operating leverage and financial leverage. It provides a comparison chart that outlines the key differences between the two types of leverage. Operating leverage is defined as a firm's use of fixed costs in operations to generate returns, while financial leverage refers to a firm's use of debt in its capital structure that requires interest payments. The degree of operating leverage measures the impact on EBIT from sales changes, while the degree of financial leverage measures the impact on EPS from EBIT changes. A low degree of operating leverage is generally preferred to reduce business risk, while a high degree of financial leverage is preferred when the return on capital employed exceeds the cost of debt.

    Copyright:

    © All Rights Reserved
    Download as DOCX, PDF, TXT or read online from Scribd
    Download as docx, pdf, or txt
    244 views7 pages

    Leverage

    Uploaded by

    Chiranjeev Routray
    The document discusses operating leverage and financial leverage. It provides a comparison chart that outlines the key differences between the two types of leverage. Operating leverage is defined as a firm's use of fixed costs in operations to generate returns, while financial leverage refers to a firm's use of debt in its capital structure that requires interest payments. The degree of operating leverage measures the impact on EBIT from sales changes, while the degree of financial leverage measures the impact on EPS from EBIT changes. A low degree of operating leverage is generally preferred to reduce business risk, while a high degree of financial leverage is preferred when the return on capital employed exceeds the cost of debt.

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    © All Rights Reserved
    Download as DOCX, PDF, TXT or read online from Scribd
    Download as docx, pdf, or txt
    of 7

    Q.1 A firm has sales of Rs. 20,00,000, variable cost of Rs.

    14,00,000 and
    fixed costs of Rs. 4,00,000 and debt of Rs. 10,00,000 at 10% rate of
    interest. What are the operating, financial and combined leverages? If
    the firm wants to double its Earnings before Interest and Tax (EBIT),
    how much of a rise in sales would be needed on a percentage basis?

    olution:

    Q.2 A firm has sales of Rs. 75,00,000, variable cost of Rs. 42,00,000 and
    fixed cost of Rs. 6,00,000. It has a debt of Rs. 45,00,000 at 9% and
    equity of Rs. 55,00,000.
    (i) What is the firm’s ROI?

    (ii) Does it have favourable financial leverage?

    (iii) If the firm belongs to an industry whose asset turnover is 3, does it have a high
    or low asset leverage?

    (iv) What are the operating, financial and combined leverages of the firm?

    (v) If the sales drop to Rs. 50,00,000, what will be the new EBIT?

    (vi) At what level the EBT of the firm will be equal to zero?
    Solution:
    Operating Leverage vs Financial leverage
    (Comparison Table)
    Basis for Comparison

    between Financial Leverage Operating Leverage Financial Leverage

    vs Operating Leverage

    Operating leverage can be defined as Financial leverage can be define

    1. Meaning firm’s ability to use fixed costs to generate firm’s ability use capital structure

    more returns. better returns and to reduce taxe

    2. What it’s all about? It’s about the fixed costs of the firm. It’s about the capital structure of

    Operating leverage measures the Financial leverage measures the


    3. Measurement
    operating risk of a business. risk of a business.

    Operating leverage can be calculated


    Financial leverage can be calcul
    4. Calculation when we divide contribution by EBIT of
    when we divide EBIT by EBT of
    the firm.

    5. Impact When degree of operating leverage is When degree of financial levera

    higher, it depicts more operating risk for higher, it depicts more financial
    the firm and vice versa. the firm and vice versa.

    Financial leverage has a direct


    The degree of operating leverage is
    6. In relation with relationship with the liability side
    usually higher than Break Even Point.
    balance sheet.

    7. How much it is
    The preference is lower. The preference is much higher.
    preferred?

    Difference Between Operating Leverage and Financial Leverage

    July 8, 2015 By Surbhi S Leave a Comment

    In
    general, leverage means affect of one variable over another. In financial management, leverage
    is not much different, it means change in one element, results in change in profit. It implies,
    making use of such asset or source of funds like debentures for which the company has to pay
    fixed cost or financial charges, to get more return. There are three measures of Leverage i.e.
    operating leverage, financial leverage, and combined leverage. The operating
    leverage measures the effect of fixed cost whereas the financial leverage evaluates the effect
    of interest expenses.

    Combined Leverage is the combination of the two leverages. While operating leverage delineates
    the effect of change in sales on the company’s operating earning, financial leverage reflects the
    change in EBIT on EPS level. Check out the article given below to understand the difference
    between operating leverage and financial leverage.
    Content: Operating Leverage Vs Financial Leverage

    1. Comparison Chart
    2. Definition
    3. Key Differences
    4. Conclusion

    Comparison Chart

    BASIS FOR
    OPERATING LEVERAGE FINANCIAL LEVERAGE
    COMPARISON

    Meaning Use of such assets in the Use of debt in a company's


    company's operations for which capital structure for which it has
    it has to pay fixed costs is known to pay interest expenses is
    as Operating Leverage. known as Financial Leverage.

    Measures Effect of Fixed operating costs. Effect of Interest expenses

    Relates Sales and EBIT EBIT and EPS

    Ascertained by Company's Cost Structure Company's Capital Structure

    Preferable Low High, only when ROCE is higher

    Formula DOL = Contribution / EBIT DFL = EBIT / EBT

    Risk It give rise to business risk. It give rise to financial risk.

    Definition of Operating Leverage

    When a firm utilizes fixed cost bearing assets, in its operational activities in order to earn more
    revenue to cover its total costs is known as Operating Leverage. The Degree of Operating
    Leverage (DOL) is used to measure the effect on Earning before interest and tax (EBIT) due to
    the change in Sales.
    The firm, which employs high fixed cost and the low variable cost is regarded as high operating
    leverage whereas the company which has low fixed cost, and the high variable cost is said to
    have less operating leverage. It is fully based on fixed cost. So, the higher the fixed cost of the
    company the higher will be the Break Even Point (BEP). In this way, the Margin of Safety and
    Profits of the company will be low which reflects that the business risk is higher. Therefore, low
    DOL is preferred because it leads to low business risk.

    The following formula is used to calculate Degree of Operating Leverage (DOL):

    Definition of Financial Leverage


    The utilization of such sources of funds which carry fixed financial charges in company’s
    financial structure, to earn more return on investment is known as Financial Leverage. The
    Degree of Financial Leverage (DFL) is used to measure the effect on Earning Per Share (EPS)
    due to the change in firms operating profit i.e. EBIT.

    When a company uses debt funds in its capital structure having fixed financial charges in the
    form of interest, it is said that the firm employed financial leverage.

    The DFL is based on interest and financial charges, if these costs are higher DFL will also be
    higher which will ultimately give rise to the financial risk of the company. If Return on Capital
    Employed > Return on debt, then the use of debt financing will be justified because, in this case,
    the DFL will be considered favorable for the company. As the interest remains constant, a little
    increase in the EBIT of the company will lead to a higher increase in the earnings of
    the shareholders which is determined by the financial leverage. Hence, high DFL is suitable.

    The following formula is used to calculate Degree of Financial Leverage (DFL):

    Key Differences Between Operating Leverage and Financial Leverage

    The following are the major differences between operating leverage and financial leverage:

    1. Employment of fixed cost bearing assets in the company’s operations is known as


    Operating Leverage. Employment of fixed financial charges bearing funds in a company’s
    capital structure is known as Financial Leverage.
    2. The Operating Leverage measures the effect of fixed operating costs, whereas Financial
    Leverage measures the effect of interest expenses.
    3. Operating Leverage influences Sales and EBIT but Financial Leverage affects EBIT and
    EPS.
    4. Operating Leverage arises due to the company’s cost structure. Conversely, the capital
    structure of the company is responsible for Financial Leverage.
    5. Low operating leverage is preferred because higher DOL will cause high BEP and low
    profits. On the other hand, High DFL is best because a slight rise in EBIT will cause a
    greater rise in shareholder earnings, only when the ROCE is greater than the after-tax
    cost of debt.
    6. Operating Leverage creates business risk while Financial Leverage is the reason for
    financial risk.

    Conclusion

    While the performance of financial analysis, Leverage, is used to measure the risk-return
    relation for alternative capital structure plans. It magnifies the changes in financial variables
    like sales, costs, EBIT, EBT, EPS, etc. The firms which use debt content in its capital structure
    are regarded as Levered Firms, but the company with no debt content in its capital structure is
    known as Unlevered firms. The multiplication of DOL and DFL will make DCL i.e. Degree of
    Combined Leverage.

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