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Measures of Leverage
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Let us today understand what does ‘leverage’ mean and its application in financial management. Leverage is nothing but the responsiveness or influence of one financial variable over some other financial variable. The focus lies on measuring how does one variable (dependent) change with the unit change in the independent variable.

For instance, XYZ Ltd. hikes its advertisement expenditure from Rs 7,000 to Rs 8,000 i.e., an increase of 14.28%; which in turn resulted in increase in number of units sold from 250 to 300 i.e., an increase of 20%. The leverage between the advertisement exp. and the number of units sold will be as follows:

Leverage = % change in units sold/ % change in advertisement exp. = 0.20/0.14 = 1.42

Now, there are two measures of leverage in financial analysis. Let us discuss them one by one.

Operating Leverage

Operating leverage tells us about how the Earnings before Interest and Taxes change when there is a change in the level of sales. This can be calculated by dividing the % change in EBIT by the % change in sales revenue.

For instance, ABC Ltd. sells 2,000 units @ Rs 20 per unit. The cost of production is Rs 6 per unit and the cost is variable in nature. The profit of the firm will be 2,000*(20-6) = Rs 28,000. Suppose, the firm is able to increase its sales level by 30% resulting in total sales of 2,600 units. The profit of the firm would now be 2,600*(20-6) = Rs 36,400.

Operating Leverage = (Increase in EBIT/EBIT) / (Increase in Sales/Sales)

= (8,400/28,000) / (12,000/40,000) = 1

This is the Degree of Operating Leverage. It is to be noted that the DOL or the degree of operating leverage arises as a result of fixed cost in the cost structure. Absence of fixed cost will result in no OL. Further, the more the fixed cost, the greater would be the operating leverage and consequently, larger will be the magnifying effect of change in sales on change in EBIT. A firm having higher DOL can experience a magnifying effect on EBIT for even a minute change in sales level. Thus, a higher degree can significantly increase the operating profit. Similarly, the EBIT may also disappear and may even give place to operating loss as a result of significant decline in sales.  Hence, a firm should strive to operate at a sufficiently higher level than the break-even so that the chances of loss due to any unexpected fluctuation in sales are minimized.

Financial Leverage

Financial Leverage measures the relationship between the EBIT and Earnings Per Share (EPS) and it reflects the effect of change in EBIT on the level of EPS. It is defined as the % change in EPS divided by the % change in EBIT.

Financial Leverage = (Increase in EPS/EPS) / (Increase in EBIT/EBIT)

For instance, a firm has an EBIT level of Rs 4,000 which increases to Rs 5,000 and the EPS increases from Rs 3.50 to Rs 4.10. The FL will be:

(1,000/4,000) / (0.60/3.50) = 0.25/0.17 = 1.47

One may note that FL arises as a result of fixed financial charge against the operating profits of the firm. Due to lesser cost of debt financing as a result of tax-shield, the surplus benefits become available to the shareholders thus, increasing the EPS.

Further, we have Combined Leverage that is nothing but the product of OL and FL as explained above. It is the effect of change in sales level on the EPS. The higher its value, the more vulnerable a company is for a decrease in sales. A high value of degree of combined leverage means that a large proportion of a company’s total costs are fixed, and any increase in sales will result in a higher EPS. Other things being equal, such companies have to generate more sales to cover their total fixed costs.

 

References: Rustagi, Dr. R.P., Basic Financial Management (2008)

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