LEVERAGE ANALYSIS | CAP CLASSES
TYPES OF LEVERAGE
The term Leverage in general refers to a relationship between two
interrelated variables. In financial analysis it represents the influence of
one financial variable over some other related financial variable. These
financial variables may be costs, output, sales revenue, Earnings Before
Interest and Tax (EBIT), Earning per share (EPS) etc.
There are three commonly used measures of leverage in financial
analysis. These are:
1) Operating
Leverage
2) Financial
Leverage
3) Combined
Leverage
OPERATING LEVERAGE
Operating leverage (OL) maybe defined as the employment of an
asset with a fixed cost in the hope that sufficient revenue will be generated
to cover all the fixed and variable costs. The use of assets for which a
company pays a fixed cost is called operating leverage. With fixed costs the
percentage change in profits accompanying a change in volume is greater than
the percentage change in volume. The higher the turnover of operating assets,
the greater will be the revenue in relation to the fixed charge on those
assets.
Operating leverage is a function of three factors:
i)
Rupee amount of fixed cost,
ii)
Contribution margin, and
iii)
Volume of sales.
Operating leverage is the ratio of net operating income before
fixed charges to net operating income after fixed charges. Degree of operating
leverage is equal to the percentage increase in the net operating income to the
percentage increase in the output.
Operating Leverage = Contribution
EBIT
Degree of operating leverage = % Change in net operating
income
%
Change in Sales
Operating leverage is directly proportional to business risk.
More operating leverage leads to more business risk, for then a small sales
decline causes a big profit.
FINANCIAL LEVERAGE
Financial leverage (FL) maybe defined as the use of funds with a
fixed cost in order to increase earnings per share. In other words, it is the
use of company funds on which it pays a limited return. Financial leverage
involves the use of funds obtained at a fixed cost in the hope of increasing
the return to common stockholders.
Degree of financial leverage is the ratio of the percentage
increase in earnings per share (EPS) to the percentage increase in earnings
before interest and taxes (EBIT).
Financial Leverage = EBIT
EBT
Degree of financial leverage = % Change in earning per share
(EPS)
% Change in EBIT
DEGREE OF COMBINED LEVERAGE
Combined leverage maybe defined as the potential use of fixed
costs, both operating and financial, which magnifies the effect of sales volume
change on the earning per share of the firm.
Degree of combined leverage (DCL) is the ratio of percentage
change in earning per share to the percentage change in sales. It indicates the
effect the sales changes will have on EPS.
DCL = DOL ×DFL
Combined Leverage = Contribution
EBT
Degree of combined leverage = % Change in EPS
% Change
in Sales
|
TABLE SHOWING COMPARISON OF OL, FL AND CL
|
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DETAILS
|
OL
|
FL
|
CL
|
|
Measurement of
|
Operating Risk
|
Financial Risk
|
Total Risk of the firm
|
|
Affected by
|
Capital Budgeting Decisions (investment Decisions)
|
Capital Structure Decisions (Financing Decisions)
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Capital Budgeting and Capital Structure Decisions (both invest
& fin decisions)
|
|
Cause
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Fixed Assets bearing Fixed operating costs
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Funds bearing fixed finance costs
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Fixed Assets & Funds bearing fixed cost
|
|
Leverage (Ratio between)
|
Contribution and EBIT
|
EBIT AND EBT
|
Contribution and EBT
|
|
Formula (Leverage)
|
C / EBIT
|
EBIT / EBT
|
C / EBT
|
|
Degree of Leverage
(Ratio between)
|
Changes in EBIT & Changes in Sales
|
Changes in EPS and Changes in EBIT
|
Changes in EPS and Changes in Sales
|
|
Formula
(Degree of Leverage)
|
Changes in EBIT / Changes in Sales
|
Changes in EPS / Changes in EBIT
|
Changes in EPS / Changes in Sales
|
TRADING ON EQUITY
1) The usage of funds with fixed financial
charges such as debt and preference capital along with the owner’s equity in
the capital employed of a company is described as financial leverage or Trading
on Equity.
2) The words financial leverage and Trading on
Equity are used synonymously. However,
the distinguishing factor between the two is as below.
a. Financial Leverage explains the impact of debt
on Earnings per share (EPS); whereas
b. Trading on Equity explains the impact of debt
on Return on Equity (ROE).
3)
Trading on
equity occurs when a company uses bonds,
debentures or loans (Debt) or Preference share capital to increase its earnings
on equity share capital.
4)
For example,
a company proposing to purchase an asset can finance the asset by way of
equity or by way of debt. If the company is opting to purchase the asset by
taking a new debt with an expectation to earn more than the interest on
the debt, it is said to be trading on equity.
5)
The earnings in
excess of the interest on the new
debt will increase the earnings of the company’s equity share capital. The
increase in earnings indicates that the company is successful in trading on
equity.
6)
If the newly
purchased assets earn less than the interest expense on the new debt, the
earnings of the equity shareholders will decrease.
7)
For Example, A
Ltd purchased an asset of Rs. 10,00,000 by way of own funds. B Ltd purchased
same asset of Rs. 10,00,000 by way of Rs. 1,00,000 equity and Rs. 9,00,000 of
debt carrying 10% rate of interest. The asset gives annual return of Rs.
1,50,000. The position of both the companies is summarized below.
Particulars
|
A Ltd
|
B Ltd
|
|
Investment in
the asset
|
10,00,000
|
10,00,000
|
|
Annual
earnings on the asset
|
1,50,000
|
1,50,000
|
|
Return on the
asset
|
15%
|
15%
|
|
Capital Structure
|
|
|
|
Equity
|
10,00,000
|
1,00,000
|
|
10% Debt
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0
|
9,00,000
|
|
Total Capital Employed
|
10,00,000
|
10,00,000
|
|
EBIT
|
1,50,000
|
1,50,000
|
|
Interest
|
0
|
90,000
|
|
EBT
|
1,50,000
|
60,000
|
|
Less: Tax @
50%
|
75,000
|
30,000
|
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PAT (EATESH)
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75,000
|
30,000
|
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Equity Share capital
|
10,00,000
|
1,00,000
|
|
Return on Equity
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7.5%
|
30%
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Formulae
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Sl No
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Leverage
|
Formula
|
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1
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Operating
Leverage
|
Contribution
EBIT
|
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2
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Financial
Leverage
|
EBIT
EBT
|
|
3
|
Combined
Leverage
|
Contribution
EBT
|
|
4
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Degree
of Operating Leverage
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% Changes in EBIT
% Changes in Sales
|
|
5
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Degree
of Financial Leverage
|
% Changes in EPS
% Changes in EBIT
|
|
6
|
Degree
of Combined Leverage
|
% Changes in EPS
% Changes in Sales
|
Problem No. 1
The
data relating to two companies are as given below:
|
Particulars
|
Company A
|
Company B
|
|
Equity capital
12% Debentures
Output (units) per
annum
Selling price/unit
Fixed Costs per
annum
Variable Cost per
unit
|
6,00,000
4,00,000
60,000
30
7,00,000
10
|
3,50,000
6,50,000
15,000
250
14,00,000
75
|
You are required to calculate the Operating
leverage, Financial leverage and Combined leverage of two companies. (PE-II-Nov.
2002) (4 marks)
Problem No. 2
Calculate the degree of Operating Leverage, Degree of Financial
Leverage and the Degree of Combined Leverage for the following firms and
interpret the results.
|
Firm
|
P
|
Q
|
R
|
|
1.
Output
2.
Fixed
Costs (Rs.)
3.
Unit
Variable Costs (Rs.)
4.
Interest
Expenses (Rs.)
5.
Unit
Selling Price (Rs.)
|
3,00,000
3,50,000
1.00
25,000
3.00
|
75,000
7,00,000
7.50
40,000
25.00
|
5,00,000
75,000
0.10
------
0.50
|
Problem No. 3
A firm’s details are as under:
Sales (@100 per unit) Rs.24,00,000
Variable Cost 50%
Fixed Cost Rs.10,00,000
It has borrowed Rs.10,00,000 @10% p.a. and its equity share
capital is Rs.10,00,000 (Rs.100 each)
Calculate:
I) Operating
Leverage II) Financial Leverage
III) Combined Leverage IV)
Return on Investment
V) If the sales increases
by Rs. 6,00,000; what will the new EBIT?
Problem No. 4
A firm sells its only product at Rs.10 per unit. Its variable
cost ratio is 70% while fixed costs are Rs.1,000. Present sales are 1000 units.
Required to find out –
(a) DOL (b) EBIT if Sales increases by 40%; (c) EBIT if Sales
falls by 25%
(d) By what % should sales fall, before the firm starts incurring
losses?
Problem No. 5
The data of two firms Rama and Krishna having the same PV ratio,
is given below. Make relevant computations and comment on their operating
risks.
|
Particulars
|
Rama
|
Krishna
|
|
Sales
Less: Variable cost
|
Rs.2,00,000
Rs.1,20,000
|
Rs.2,00,000
Rs.1,20,000
|
|
Contribution
Less: Fixed Costs
|
Rs.80,000
Rs.30,000
|
Rs.80,000
Rs.50,000
|
|
Profit
|
Rs.50,000
|
Rs.30,000
|
Problem No. 6
Consider the following information
for Omega Limited.
|
Particulars
|
Rs.
|
|
Earnings
before interest and tax (EBIT)
|
15,750
|
|
Earnings
before tax (EBT)
|
7,000
|
|
Fixed
operating costs
|
1,575
|
You are required to calculate the
percentage change in Earnings Per Share (EPS), if the sales increase by 5%.
Problem
No. 7
Consider the following information for Strong Ltd:
|
EBIT
|
1,120 Rs. in lakh
|
|
PBT
|
320 Rs. in lakh
|
|
Fixed Cost
|
700 Rs. in lakh
|
Calculate the percentage of change in earnings per share, if
sales increased by 5 per cent. (Final-Nov. 2001) (6 marks)
Problem No. 8
A Firm has sales of Rs.75 lakhs. Its variable cost and fixed
costs are Rs.42 lakhs and Rs.6 lakhs respectively. It has a debt of Rs.45 lakhs
at 9% and Equity of Rs.55 lakhs.
a) What
is the firm’s ROI?
b) Does
the firm have a favourable financial leverage?
c) If
the firm belongs to an industry whose asset turnover is 3, does it have high or
low asset leverage?
d) What
are the operating, financial and combined leverage of the firm?
e) If
Sales drop to Rs.50 lakhs, what will be new EBIT?
f) At
what level of sales, the EBT of the firm will be equal to zero?
(CA
Final-May 1997) (11 marks)
Problem No. 9
The following summarizes the percentage changes in operating
income, percentage changes in revenues and betas for four pharmaceutical firms.
|
Firm
|
Change in revenue
|
Change in operating income
|
Beta
|
|
PQR Ltd.
RST Ltd.
TUV Ltd.
WXY Ltd.
|
27%
25%
23%
21%
|
25%
32%
36%
40%
|
1.00
1.15
1.30
1.40
|
Required:
a)
Calculate
the degree of operating leverage for each of these firms. Comment also
b)
Use
the operating leverage to explain why these firms have different beta.
Problem No. 10
The following data is given in respect of three Companies.
Compute – (a) Degree of Financial Leverage; (b) EPS; if rate of EBIT on Capital
Employed is (i) 25% (ii) 10% and (iii) 8%. Interpret the results and ascertain
which Company is favourably leveraged. [Assume that Face Value per Equity Share
is Rs.10 and the Tax Rate is 40%]
|
Particulars
|
Company A
|
Company B
|
Company C
|
|
Equity Share Capital
10% Debentures
|
Rs.10 lakhs
NIL
|
Rs. 5 lakhs
Rs. 5 lakhs
|
Rs. 1 lakh
Rs. 9 lakhs
|
|
Total Capital
Employed
|
Rs.10 lakhs
|
Rs.10 lakhs
|
Rs.10 lakhs
|
Problem No. 11
From
the following prepare Income Statement of Company A, B and C. Briefly comment
on each company’s performance:
|
Company
|
A
|
B
|
C
|
|
Financial Leverage
Interest
Operating Leverage
Variable Cost as a Percentage
to Sales
Income-Tax Rate
|
3:1
Rs.200
4:1
66.67%
45%
|
4:1
Rs.300
5:1
75%
45%
|
2:1
Rs.1,000
3:1
50%
45%
|
(CA Final-Nov. 1997) (12 marks)
Problem
No. 12
Calculate the operating leverage,
financial leverage and combined leverage from the following data under
Situation I and II and Financial Plan A and B:
|
Installed
Capacity
|
4,000 units
|
|
Actual
Production and Sales
|
75% of the Capacity
|
|
Selling
Price
|
Rs. 30 Per Unit
|
|
Variable
Cost
|
Rs. 15 Per Unit
|
Fixed Cost:
Under Situation I
|
Rs. 15,000
|
|
Under
Situation-II
|
Rs. 20,000
|
Capital
Structure:
|
|
Financial Plan
|
|
|
|
A (Rs)
|
B (Rs)
|
|
Equity
|
10,000
|
15,000
|
|
Debt
(Rate of Interest at 20%)
|
10,000
|
5,000
|
|
Total
|
20,000
|
20,000
|
(CA Final-May 1996) (14 marks)
Problem
No. 13
A Company had the following Balance
Sheet as on March 31, 2006:
|
Liabilities
|
Rs. (in crores)
|
Assets
|
Rs. (in crores)
|
|
Equity Share Capital
(one crore shares of Rs. 10 each)
|
10
|
Fixed Assets (Net)
|
25
|
|
Reserves and Surplus
|
2
|
Current Assets
|
15
|
|
15% Debentures
|
20
|
|
|
|
Current Liabilities
|
8
|
|
___
|
|
|
40
|
|
40
|
The additional information
given is as under:
Fixed Costs per annum (excluding interest) Rs. 8 crores
Variable operating costs ratio 65%
Total Assets turnover ratio 2.5
Income-tax rate 40%
Required:
Calculate the following and
comment:
(i) Earnings per share (ii) Operating
Leverage (iii) Financial Leverage
(iv) Combined
Leverage. (PE-II-Nov. 2006)(8 marks)
Problem
No. 14
X Limited
has estimated that for a new product its breakeven point is 20,000 units if the
item is sold for Rs. 14 per unit and variable cost is Rs. 9 per unit. Calculate
the degree of operating leverage for sales volume of 25,000 units and 30,000
units.
Problem No. 15
The
following information related to XL Company Limited for the year ended 31st
March, 2016 are available to you:
|
Equity share capital
|
25,00,000
|
|
11% Bonds of Rs. 1000 each
|
18,50,000
|
|
Sales
|
42,00,000
|
|
Fixed Cost (excluding interest)
|
3,48,000
|
|
Financial Leverage
|
1.39
|
|
Profit Volume Ratio
|
25.55%
|
|
Income tax rate
|
35%
|
You
are required to calculate:
1)
Operating Leverage
2)
Combined Leverage and
3)
Earnings per share
Problem No. 16
Alpha
limited has furnished the following balance sheet as on 31st March,
2016
|
Liabilities
|
Rs
|
Assets
|
Rs
|
|
Equity Share capital
(1,00,000 equity shares of Rs. 10 each
|
10,00,000
|
Fixed Assets
|
30,00,000
|
|
General Reserve
|
2,00,000
|
Current Assets
|
18,00,000
|
|
15% Debentures
|
28,00,000
|
|
|
|
Current Liabilities
|
8,00,000
|
|
|
|
|
48,00,000
|
|
48,00,000
|
Additional
Information:
1)
Annual fixed cost other than interest :
28,00,000
2)
Variable Cost Ratio: 60%
3)
Total Assets Turnover Ratio : 2.5
4)
Tax rate: 30%
You
are required to calculate:
1)
Earnings per share (EPS) and
2)
Combined Leverage
Problem No. 17
From
the following financial data of Company A and Company B, prepare their income
statements.
|
Particulars
|
Company A
|
Company B
|
|
Variable Cost
|
56,000
|
60% of sales
|
|
Fixed Cost
|
20,000
|
-
|
|
Interest Expense
|
12,000
|
9,000
|
|
Financial Leverage
|
5:1
|
-
|
|
Operating Leverage
|
-
|
4:1
|
|
Income tax rate
|
30%
|
30%
|
|
Sales
|
-
|
1,05,000
|
Problem No. 18
A
company operates at a production level of 1,000 units. The contribution is Rs.
60 per unit, operating leverage is 6 and combined leverage is 24. If tax rate is
30%, what would be its earnings after tax?
Problem No. 19
From
the following data relating to RT Ltd, calculate, operating leverage, financial
leverage and combined leverage
|
Particulars
|
Rs.
|
|
Earnings before interest and tax (EBIT)
|
10,00,000
|
|
Fixed Cost
|
20,00,000
|
|
Earnings before tax (EBT)
|
8,00,000
|
Problem No. 20
A
firm has sales of Rs. 40,00,000, Variable cost of Rs 25,00,000, Fixed cost of
Rs. 6,00,000, 10% Debt of Rs. 30,00,000 and Equity capital of Rs. 45,00,000.
Calculate
operating leverage, financial leverage, combined leverage and return on capital
employed of the firm.
Problem No. 21
The
following details of RST Limited for the year ended 31st March, 2016
are given below:
|
Operating Leverage
|
1.4
|
|
Combined Leverage
|
2.8
|
|
Fixed Cost (excluding interest)
|
Rs. 2.04 Lakhs
|
|
Sales
|
Rs. 30.00 Lakhs
|
|
12% Debentures of Rs. 100 each
|
Rs. 21.25 Lakhs
|
|
Equity Share capital of Rs. 10 each
|
Rs. 17.00 Lakhs
|
|
Income tax rate
|
30%
|
Required:
1) Calculate financial leverage
2) Calculate P/V Ratio
3) Calculate Earnings per share (EPS)
4) If the company belongs to an industry, whose asset turnover is
1.5, does it have a high or low assets leverage?
5) At what level of sales the Earnings before Tax (EBT) of the
company will be equal to zero?
Problem
No. 22
Z
Limited is considering the installation of a new project costing Rs.80,00,000.
Expected annual sales revenue from the project is Rs.90,00,000 and its variable
costs are 60% of sales. Expected annual fixed cost other than interest is Rs.10,00,000.
Corporate tax rate is 30%. The company wants to arrange the funds through
issuing 4,00,000 equity shares of Rs.10 each and 12% debentures of Rs.40,00,000
You are required to:
1) Calculate the operating, financial and combined leverages and
Earnings per share (EPS)
2) Determine the likely level of EBIT, if EPS is (1) Rs. 4 (2) Rs. 2
and (3) Rs. 0
Problem
No. 23
A
company operates at a production level of 5,000 units. The contribution is Rs.
60 per unit, operating leverage is 6, combined leverage is 24, tax rate is 30%,
what would be its earnings after tax?
Problem No. 24
Annual
sales of a company is Rs. 60,00,000. Sales to variable cost ratio is 150
percent and fixed cost other than interest is Rs. 5,00,000 per annum. Company
has 11 percent debentures of Rs. 30,00,000.
You
are required to calculate the operating, financial and combined leverage of the
company.
Problem
No. 25
The net sales of A Ltd. is Rs.30 crores. Earnings before
interest and tax of the company as a percentage of net sales is 12%. The
capital employed comprises Rs.10 crores of equity of Rs.10 Face value each, Rs.2
crores of 13% Cumulative Preference Share Capital and 15% Debentures of Rs.6
crores. Income-tax rate is 40%.
(i)
Calculate Return on Capital Employed, Return on
equity and Return on Equity shareholders funds.
(ii)
Calculate EPS
Calculate the Operating Leverage of the Company
given that combined leverage is 3. 
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