J B GUPTA CLASSES

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APPENDIX C

LEVERAGE
Leverage1 is an assisted advantage. To leverage means to gain an advantage
through the use of a tool. In the word of finance, the term is applied to (i) fixed
cost and (ii) cost of fixed commitment funds (interest, preference dividend) as
being used to maximize the EPS. There are three types of leverage (i) Operating
Leverage (ii) Financial leverage and (iii) Combined leverage.
Operating leverage is tendency of EBIT to vary disproportionately with sales.
This happens because every enterprise has fixed costs which have to be met
regardless of volume of sales. Fixed costs remain fixed whether sales increase
or decrease. Therefore the percentage changes in operating profit on account of
a change in sales is greater than the percentage change in sales.

Financial leverage can be defined as the tendency of the EBT to vary

disproportionately with net operating income (EBIT). In other words, change in
EBIT results in a larger change in EBT (and accordingly in EAT, also in EPS).
This happens because of fixed commitments on debentures, loans, etc. Hence, if
there is a change in EBIT, it will result a larger change in the return of owner’s
funds. Financial leverage will be higher in case of firms with higher debt equity
ratio.

Operating leverage indicates towards business risk (i.e. possibility suffering loss
in case of fall in sates) and financial leverage indicates towards financial risk
(i.e., possibility of bankruptcy in case of fall in EBIT). The total risk involved can
be seen by combining the operating leverage and financial leverage. This
combination is known as composite leverage.

1
A lever is a device that (i) multiplies the force and (ii) a makes it available at a
particular point. A pair of scissors is a common example of lever, what we cannot
cut (without using the pair of scissors) by applying all our force, we can cut
(applying the same force, or sometimes lesser force) the same using the pair of
scissors. (the pair of scissor multiplied our force and provided at the point
where the cut was required )
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Example:

Rs. Rs
Sales 1,00,000 1,10,000
VC 50,000 55,000
Contribution 50,000 55,000
F.C. 20,000 20,000
EBIT (operating profit) 30,000 35,000
Interest 5,000 5,000
E.B.T. 25,000 30,000
Tax 12,500 15,000
E.A.T. 12,500 15,000
E.P.S. (assumed 10,000 shares) 1.25 1.50

In the above example, we find that when sales increased by 10%,

EBIT (operating profit) increase by (5000 / 30000) x 100 = 16.66 %. This
tendency, i.e. operating profit changes at a higher rate than that of rate of
change of sales, it known as operating leverage. When operating profit changed
by 16.66 percent, EBT changed by 20 percent, EAT changed by 20 percent, EPS
also changed by 20 percent. This tendency, i.e. EBT, EAT or EPS changes at a
higher rate, than that rate of change of EBIT, is known as financial leverage. The
tendency of disproportionate change of EBT/EAT/EPS on change in sales is
known as composite leverage.

% change in EBIT
Operating leverage =
% change in Sales

16.67
= = 1.667
10

% change in EBT or EAT or EPS

Financial Leverage =
% change in EBIT
20
= = 1.20
16.67
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% change in EBT or EAT or EPS

Combined Leverage =
% change in sales

20
= = 2
10
Short-
Short-cut ways of calculation
Operating leverage = Contribution/EBIT
50,000
= = 1.666
30,000
Financial leverage = EBIT/EBT
30,000
= 1.20
25,000

Composite leverage = Contribution/EBT

50,000
= 2
25,000

This note is based on the assumption that there is no preference dividend. If

preference dividend is there, replace, in the above note, (i) the term EBT by
“EBT – pre tax profit required to pay the preference dividend” & (ii) the term
EAT by EAT – preference dividend including dividend distribution tax(es) if any.”

Interpretation of Leverages

If degree of operating leverage is 2, it means for every 1 per cent increase in

sales, EBIT will be up by 2 per cent.

If degree of financial leverage is 2, it means for every 1 per cent increase

in EBIT, EBT/EAT/EPS will go up by 2 per cent.

If degree of composite leverage is 4, it means for every 1 per cent

increase in sales, EBT/EAT/EPS will go up by 4 per cent.

Q. No. 1 : The net sales of A Ltd. is 30 Crores, EBIT is 12% of sales. The Capital
employed. ESC Rs.10 Crores, 13% PSC Rs.2 Crores and 15% Debentures Rs.6
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Crores. Tax 40%. Ignore CDT, education cess and surcharge. Calculate return on
equity and indicate its segments due to presence of PSC and debentures. Given
that the combined leverage is 4, calculate the operating leverage

Answer:
Answer
EBIT = 12% of 30 Crores Rs.3.60 Crores
Interest Rs.0.90 Crores
Tax Rs.1.08 Crores
EAT Rs.1.62 Crores
Pref. Dividend Rs.0.26 Crores
Earnings for equity shareholders Rs.1.36 Crores
ESC Rs.10.00 Crores
Return on equity (1.36/ 10.00) x 100 = 13.60 %

Return on capital employed =

[EBIT] / [(ESC + PSC + DEBT)] = [3.60] / [10 + 2 + 6 ] = 20%
Calculation of profit for equity shareholders: (Rs. Crores)
Source of Earnings Interest Tax Pref. Profit for equity
funds on funds Div. shareholders
Equity 10 x 0.20 0.80 1.20
Pref. 2 x 0.20 0.16 0.26 - 0.02
Debt 6 x 0.20 6 x 0.15 0.12 0.18
Total 13.60
Segments of Return on equity :
ESC funds ( 1.20 / 10 ) x 100 = 12.00%
Pref. Funds (-0.02/ 2 ) x 100 = - 0.20%
Debt. Funds (0.18 /10) x100 = 1.80%
Total 13.60 %
(ii) EBIT 3.60 Crores
Interest -0.90 Crores
EBT 2.70 Crores

EBIT
F. leverage = ----------------------------------------
“EBT – pre tax profit required to pay pref. dividend”

3.60 Crores
= ----------------------------- = 1.5882
2.70 – [(0.26) x (100/60)
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Combined Leverage = Operating Leverage x Financial leverage

4 = Operating leverage x 1.5882 Operating leverage = 2.5186

Q. No.2 :Operating leverage of an organization has been increased from 4 last year to 5
during the current year. Fixed overheads have increased by 5% during the current year
compared to last year. Sales have also increased by 8% over last year. Assess to what
extent the profit of current year is likely to change over last year.

Answer
Let contribution = 100 Let FC = x

Last year 4 = 100 / (100 – x) FC = 75 profit = 25

This year FC = 78.75
5 = Cont / ( cont – 78.50)
Cont. = 98.4375
Profit = 98.4375 – 78.75 = 19.6875

% change in profit = [(25 – 19.6875) / 25 ] x 100 = 21.25

Q. No. 3:
3: A firm has a sales of Rs. 6 crores, Variable cost Rs. 3.5 crores and
Fixed cost of Rs. 0.65 crores. The firm has debt and equity resources worth of
Rs.7 crores and 10 crores respectively. With the date given show:
(i) The firm’s ROI.

(ii) EBIT if sales decline to Rs. 4 crores.

(iii) If the industry’s assets turnover is 4 times, does the firm has high or
low asset turnover ? The cost of debt is 10%, ignore taxation. (6
Marks) (Nov.
(Nov. 2006)
Answer
Rs. Crores
Sales 6
VC 3.50
FC 0.65
EBIT 1.85
ROI = (1.85/17) x 100 = 10.88
Rs. Crores
Sales 4
VC 2.33
FC 0.65
EBIT 1.02
Assets turnover = sales / assets = 6/17 = .3529
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It is very low as compared to industry.

Q. No.4:
No.4: Consider the following information:
EBIT Rs,1120 Lakhs PBT Rs.320 Lakhs Fixed Cost Rs.700 Lakhs.
Find the % change in EPS if sales increased by 5%. (Nov. 2001) (6 marks)

Answer
Operating leverage = Contribution / EBIT
= 1820/1120 = 1.625
Financial leverage = EBIT / EBT = 1120/320 = 3.50

Composite leverage = 1.625 x 3.50 = 5.6875

Composite leverage = % change in EPS / % change in sales

5.6875 =% change in EPS / 5
% change in EPS = 28.4375