What is Leverages? Operating, Financial, Combined

What is Leverages?

The term leverage refers to a person’s ability to exert influence or authority. The influence of one financial variable on another related financial variable is referred to as leverage in financial analysis. Costs, output, sales revenue, EBIT, EPS and other financial factors may be included.

The impact of a change in variable X on variable Y is commonly referred to as Leverage of Y with X, and it is calculated as follows:

Measurement of leverage Change in Y Y
Change in X X

Following are the definitions of leverage given by renowned financial scholars:

• According to J.C. Van Home, Leverage is the employment of an asset or funds for which the firm pays a fixed cost of fixed return.
  
  
• Leverage, according to James Horne, is the use of an asset or finances for which the firm pays a fixed cost or fixed return.
  
  
• Leverage, according to Christy and Roder, is the tendency for earnings to change at a quicker rate than sales.

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Operating Leverage

Operating leverage is the use of fixed operating costs in the company’s operations but excludes interest on debt capital. Fixed operating cost includes depreciation, insurance of assets, repairs and maintenance, property taxes, etc. If there is higher proportion of fixed operating cost than variable cost, the operating leverage will be higher and vice versa.

Operating leverage occurs when a change in revenue results in a larger change in EBIT. It has something to do with fixed costs. A company with high fixed costs utilises a large portion of its marginal contribution to cover those costs. It alludes to the extensive use of fixed assets.

Operating leverage is a function of three factors:

• Fixed costs
• Contribution
• Volume of sales

Following are the important characteristics of operating leverage:

• Operating leverage affects the assets side of company’s balance sheet
• Operating leverage is associated with the composition of fixed assets
• Operating leverage is related to fluctuations or variations in business risk
• Operating leverage impacts the capital structure and return on total assets

Example:

A firm sells its product at 100%, as variable operating cost of 50% and fixed operating cost of 50,000 per year. Show the various levels of EBIT that would result from sale.

• 1,000 units
• 2,000 units
• 3,000 units.

Solution:

	Case 2 –50%	Base Data	Case 1 +50%
Sales in units	1,000	2,000	3,000
Sales revenue	1,00,000	2,00,000	3,00,000
Less variable operating costs	50,000	1,00,000	1,50,000
Contribution	50,000	1,00,000	1,50,000
Less fixed operating costs	50,000	50,000	50,00
EBIT	ZERO	50,000	1,00,000
	–100%		+100%

From the above results, certain generalization can be made.

Case I: A 50% increase in sales (from 2,000 to 3,000 units) results in a 100% increase in EBIT (from 50,000 to 1,00,000).

Case II: A 50% decrease in sales (from 2,000 to 1,000 units) results in a 100% decrease in EBIT (from 50,000 to zero).

Hence, Operating leverage Percentage change in EBIT
Percentage change in sales

=
100%
50%
+
+
= 2 (case I)

=
100%
50%
−
− =2 (case II)

Degree of Operating Leverage (DOL)

The degree of operating leverage can be used to assess the behaviour of operating leverage. The percentage change in earnings as a result of a percentage change in sales is the degree of operating leverage. It can be expressed using the following formula:

Degree of Operating Leverage = Percentage change in EBIT
Percentage change in Sales

The percentage change in earnings before interest and taxes compared to a given percentage change in sales is known as the degree of operating leverage (DOL). To find the DOL, use the below mentioned formula:

Example:

Calculate the degree of operating leverage from the following data:

Sales: 1, 50,000 units at ₹4 per unit.

Variable cost per unit ₹2.

Fixed cost ₹1, 50,000.

Interest charges ₹25,000.

Solution:

Here,

Sales = 1,50,000 × ₹4	6,00,000
Less: Variable cost: 1,50,000 × ₹2	3,00,000
Contribution	3,00,000
Less: -Fixed Cost	1,50,000
EBIT	1,50,000

DOL = 3,00,000
1,50,000
= 2

Break-Even Analysis and Operating Leverage

Break-even analysis is the financial tool for studying the relationship between the variable cost, fixed cost and revenue. Break-even analysis is used by the firm for the following purposes:

• To determine the level of operations necessary to cover all operating costs and
  
  
• To determine the profitability at different levels of sales. The quantity of sales required to cover all operational costs is known as the firm’s operating break-even point (BEP). Earnings before interest and taxes is equal to zero at BEP

The firm’s operating breakeven point is sensitive to a number of variables such as fixed operating cost, the sales price per unit and the variable cost per unit.

Table shows the effects of increase or decrease in variables:

Increase in variable	Effect on operating break-even
Fixed operating costs	Increase
Sales price per unit	Decrease
Variable operating cost per unit	Increase

Operating leverage is affected by changes in fixed operating costs. Significantly, the firm’s operating leverage and risks increase as fixed operating costs rise. When revenues are rising, high operating leverage is beneficial, when revenues are down, it is detrimental. Use below mentioned formulae for calculating break-even point:

Break-even point= Total fixed cost/Contribution per unit

Contribution per unit = Selling price per unit – Variable cost per unit

Let us understand how to find the break-even point:

• Variable costs per unit is 400 rupees
• Sale price per unit is 600 rupees
• Desired profits is 4,00,000 rupees
• Total fixed costs is 10,00,000 rupees

Calculate the break-even point per unit.

Solution: Contribution per unit= Sales price per unit − Variable costs per unit = 600−400

Contribution per unit = ₹200

Break-Even Point = Total fixed cost/Contribution per unit 10,00,000/ 200 = 5,000 units

Next, for changing unit into rupees multiplying 5,000 units with the selling price, i.e., 600 rupees.

Break-Even Sales at 5,000 units × ₹600 = ₹30,00,000.

Margin of Safety and Operating Leverage

The difference between current sales and break-even sales is a company’s margin of safety. The margin of safety indicates how much money the company can lose in sales before it loses money, or before it falls below the break-even threshold. The lower the chance of not breaking even or losing money, the bigger the margin of safety.

The following formula is used to calculate the margin of safety:

Margin of safety = Total budgeted (or actual sales) – Break-even sales

Let us understand the margin of safety with the help of an example.

XYS manufacturer find the breakeven to be 100 units. On the basis of sales projections, the company estimated selling of 150 units during the next quarter. Find out the margin of safety.

Solution: Margin of safety = Total budgeted (or actual sales) – Breakeven sales = 150 – 100

Margin of Safety = 50 units

This margin of safety indicates that a company could potentially lose 50 sales during the period without creating a loss from operations.

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Financial Leverage

Financial leverage is defined as a company’s capacity to employ fixed financial costs in such a way that every change in EBIT has a magnifying effect on EPS. In other words, financial leverage is the process of increasing the return on equity through the use of debt capital.

The following are the essentials of financial leverage:

• It affects the liabilities side of balance sheet.
  
  
• It is related to capital structure.
  
  
• It depicts the financial risk.
  
  
• It affects earning after tax and EPS.
  
  
• It may be favourable or unfavourable for the company. Unfavourable leverage occurs when the company does not earn as much as the funds cost.

Example:

C Company Ltd. is a small food company expects EBIT of 10,000 in the current year. It has ₹20,000 bonds with 10% (annual) coupon rate of interest and 600 shares of ₹4 (annual dividend on share) preferred stock outstanding. It has also 1,000 equity shares outstanding. The firm is in the 40% tax bracket.

Two situations are shown:

Case 1: A 40% increase in EBIT from ₹10,000 – ₹14,000

Case 2: A 40% decrease in EBIT from ₹10,000 – ₹6,000

The corresponding change in EPS is shown below:

	Case 2 – 40%	Base data	Case 1 + 40%
EBIT	₹6,000	10,000	14,000
Less interest	2,000	2,000	2,000
Net profit before tax	4,000	8,000	12,000
Less tax @ 40%	1,600	3,200	4,800
Net profit after tax	2,400	4,800	7,200
Less preferred stock dividend	2,400	2,400	2,400
Earnings available to equity shares	0	2,400	4,800
No. of shares	1,000	1,000	1,000
Earnings per share (EPS)	0	₹2.40	₹4.8
	100% +100%

It is seen that in:

Case No. I – A 40% increase in EBIT has resulted in a 100% increase in earnings per share (from ₹2.40 to 4.80).

Case No. II – A 40% decrease in EBIT has results in a 100% decrease in earnings per share (from ₹2.40 to 0).

i.e., financial leverage is:

=
100%
40% = 2.5

Degree of Financial Leverage (DFL)

The degree of financial leverage is a financial measurement that gauges a company’s overall profitability’s sensitivity to operating income volatility induced by changes in its capital structure. One of the measures used to quantify a company’s financial risk is the degree of financial leverage (the risk associated with how the company finances its operations).

The degree of financial leverage can be calculated in a variety of ways. The calculation method chosen is determined by the analysis objective and circumstances. For example, a company’s management may want to decide whether or not to issue additional debt. In this situation, net income would be a good indicator of the firm’s profitability.

Check the formula mentioned below:

Degree of Financial Leverage = % Change in Net Income
% Change in EBIT

However, because of the metric’s strong association with the company’s share price, EPS is a more appropriate measure for determining the impact of the company’s choice to incur further debt. Check the formula mentioned below:

Degree of Financial Leverage = % Change in EPS
% Change in EBIT

Finally, there is a formula that can be used to calculate the degree of financial leverage over a certain length of time:

Degree of Financial Leverage = EBIT
EBIT – Interest

Financial Leverage as ‘Trading on Equity’

Financial leverage as ‘trading on equity’ refers to a corporation’s use of its financial strength to obtain debt and increase shareholder earnings. In other words, a company’s equity strength is used to obtain debts from creditors, hence the strategy’s name.

Based on that understanding, there are two variants of trading on equity:

• Trading on thin equity
• Trading on thick equity

In the first scenario, a corporation debt financing is greater than its equity strength. In the latter situation, a corporation obtains a small debt in comparison to its equity strength. As previously stated, firms hope to enhance their income by acquiring new assets and creating returns that are larger than the cost of debt they obtain by trading on equity.

As a result, the surplus income boosts the earnings per share of shareholders (EPS). It’s an indicator that a company’s approach was successful. However, if the strategy does not work out as planned, the earnings will be lower than the interest costs. As a result, the income of the shareholders is reduced. This is an evidence of the strategy’s failure to be implemented.

Financial Leverage as a ‘Double Edged Sword

Other than operating leverage, financial leverage is the second type of leverage. When we talk about financial leverage, we’re talking about debt being included in a company’s capital structure. Why is debt inclusion so important? To begin with, the cost of debt is lower than the cost of equity. As a result, including debt lowers your overall cost of capital, making your capital structure more optimal.

However, there is a downside to using leverage. Payment of principal and interest is a recurring obligation that increases your financial risk. When the market is down, this risk becomes more evident because you have less operating profit to service your increased leverage.

Financial leverage is thus a double-edged sword, as it lowers your cost of financing while also increasing your risk of insolvency. What exactly is financial leverage, and how can it assist a business? Let us take a look at how smart leverage might boost a company’s earnings. It is important to note, however, that it comes with the possibility of bankruptcy and decreased value.

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Combined Leverage

The possible use of fixed costs, both operating and financial, to magnify the effect of fluctuations in sales on the firm’s earnings per share is known as combined leverage or total leverage. Whole leverage, also known as combined leverage, refers to the total influence of fixed costs on a company’s operating and financial structure.

Combined leverage = Operating leverage × Financial leverage

The combination of a high operating leverage and a high financial leverage is extremely dangerous. If the corporation produces and sells at a high level, it will create a huge profit for its investors. However, even a slight reduction in operations would result in a significant drop in earnings per share. As a result, a corporation must strike a correct balance between these two leverages.

A high operating leverage combined with low financial leverage implies that management is cautious, since the higher risk associated with high operating leverage has been tried to be offset by low financial leverage. However, having a low operating leverage and a high financial leverage might be a better alternative. A cautious and careful management will maintain both the operating leverage and the financial leverage at a minimum, but this strategy may result in the company missing out on valuable chances.

Degree of Combined Leverage (DCL)

The Degree of Combined Leverage (DCL) is a leverage ratio that averages the combined effect of the DOL and the Degree of Financial Leverage (DFL) on EPS for a given change in Sales. This ratio aids in determining the best feasible financial and operational leverage for any organisation.

Formula for Degree of Combined Leverage (DCL)

The formula used for ascertaining the DCL is:

DCL = %Change in EPS / %Change in Sales = DOL × DFL

This ratio is regarded to be very valuable to a corporation or firm because it aids in understanding the impacts of combining financial and operating leverage on a company’s total earnings. A high level of combined leverage indicates that the company is at risk since it has more fixed costs, whereas a low level of combined leverage indicates that the company is doing well.

Analysis of Combined Leverage

Combine leverage measures total risk. It depends on a combination of operating and financial risk. Table shows the analysis of combined leverage:

DOL	DFL	Comments
Low	Low	Lower total risk. Cannot take advantage of trading on equity.
High	High	Higher total risk. Very risky combination.
High	Low	Moderate total risk. Not a good combination. Lower EBIT due to higher DOL and lower advantage of trading on equity due to low DFL.
Low	High	Moderate total risk. Best combination. Higher financial risk is balanced by lower business risk.