1. ANALYSIS OF LEVERAGE

• Introduction

Leverage provides the framework for financing decisions of a firm. It may be defined as the employment of an asset/source of funds for which the firm has to pay a fixed cost, or fixed return.

Types of leverage

Leverage may be (i) Operating, (ii) Financial, or (iii) Combined

2. OPERATING LEVERAGE

Leverage associated with asset acquisition/investment activities is referred to as theoperating leverage.It may be defined as the ability to use fixed operating costs to magnify the effect of changes in sales on its operating profits (EBIT). Thus, operating leverage is determined by the relationship between sales revenue and EBIT. When proportionate change in EBIT as a result of change in sales is more than the proportionate change in sales, operating leverage occurs.

OR 3. OPERATING LEVERAGE-CONTINUED 4. FINANCIAL LEVERAGE

Financial leverage is the second type of leverage. It is related to the financing activities of a firm. It results from the presence of fixed financial charges. Such expenses dont vary with operating profits (EBIT). They have to be paid regardless of the amount of EBIT available to pay them. After paying them, the EBIT belongs to the shareholders. Financial leverage is concerned with the effect of changes in EBIT on the earning available to the shareholders (EPS). It may be defined as a ability of a firm to use fixed financial charges to magnify the effect of changes in EBIT on EPS.

ie. Earning after interest but before tax. 5. COMBINED LEVERAGE

Combined leverage is the product of operating and financial leverage. It indicates the effect that sales changes will have on EPS.

Alternatively