OPERATING, FINANCIAL & COMBINED LEVERAGE

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Operating Leverage:

WITH FIXED COSTS, THE PERCENTAGE CHANGE IN PROFITS ACCOMPANYING A CHANGE IN VOLUME OF SALES IS GREATER THAN THE PERCENTAGE CHANGE IN VOLUME OF SALES.

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Operating Leverage

Sales Variable cost Fixed cost Profit CASE I BASE 1,00,000 2,00,000 50,000 50,000 Nil 50,000 1,00,000 50,000 CASE II 3,00,000 50,000 1,50,000 1,00,000

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Operating Leverage

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Financial Leverage

THE ABILITY OF A FIRM TO USE FIXED FINANCIAL CHARGES TO MAGNIFY THE EFFECTS OF CHANGES IN EBIT ON THE FIRM'S EARNINGS PER SHARE. i.e.; Financial Leverage involves the use of funds obtained at a fixed cost in the hope of increasing the return to the shareholders.
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Financial Leverage
CASE I Less: Interest on debt EBT Less: Tax @ 50% EAT Less: Preference Dividend Earnings available to Equity Shareholders
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BASE 1,00,000 20,000 80,000 40,000 40,000 20,000

CASE II 1,40,000 20,000 1,20,000 60,000 60,000 20,000

EBIT

60,000 20,000 40,000 20,000 20,000 20,000

Nil

20,000

40,000

Favourable or positive Leverage

WHEN THE FIRM EARNS MORE ON THE ASSETS PURCHASED WITH THE FUNDS, THAN THE FIXED COST OF THEIR USE.

Unfavourable or negative Leverage

WHEN THE FIRM EARNS LESS ON THE ASSETS PURCHASED WITH THE FUNDS, THAN THE FIXED COST OF THEIR USE. 4/27/12

Financial Leverage

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Alternative Definition of Financial Leverage

DFL = Percentage change in EPS Percentage change in EBIT >1

DFL

Percentage Change in earnings available to shareholders Percentage change in EBIT

>1

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Combined Leverage:

The operating leverage and the financial leverage are both closely concerned with ascertaining the ability to cover fixed charges (fixed operating costs in the case of operating leverage and fixed financial costs in the case of financial leverage). If they are combined, the result is total leverage and risk associated with combined leverage is 4/27/12 known as total risk.

Combined Leverage

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Combined Leverage

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EBIT EPS ANALYSIS

The EBIT EPS analysis is a widely used means to examine the effect of leverage by analyzing the relationship between EBIT & EPS. A firm has the choice to raise funds for financing its investment proposals from different sources and in different proportions. The choice of a combination of the various sources would be one which, given 4/27/12

Indifference Point

The EBIT level at which the EPS is the same for two alternative financial plans is referred to as indifference point/level. The indifference point may be defined as the level of EBIT beyond which the benefits of financial leverage begin to operate with respect to earnings per share (EPS). In operational terms, if the expected level is to exceed the indifference level of EBIT, 4/27/12