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Analysis of Operating and Financial Leverages
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Transcript of Analysis of Operating and Financial Leverages
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7/29/2019 Analysis of Operating and Financial Leverages
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Analysis of operating and
financial leverages
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MEANING
The term leverage refers to meansof accomplishing power for gainingan advantage. Leverage refers to theability of a firm in employing longterm funds having a fixed cost, toenhance returns to the owners. In
other word leverage is theemployment of fixed assets or fundsfor which a firm has to meet fixedcosts or fixed rate of interest
obligation irrespective of the level of
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OPERATING LEVERAGE
Operating leverage is concerned withthe operation of any firm.The coststructure of any firm gives rise tooperating leverage because of theexistence of fixed nature of costs.
This leverage relates to the sale and
profit varaiation.
Operating Leverage = Contribution
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DEGREE OF OPERATINGLEVERAGE Percentage change in EBIT
% EBIT
= ________________________ OR
________Percentage change in sales
% Q
The degree of operating leverage canalso be expressed as follows:
Q (P V)
DOL = _________
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below:
_____________________________
___________________________
Units Manufactured and sold Firm X (20,000 )Firm Y(20,000)
Direct Material 1010
Direct Labour 5
5
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Solution:
Particulars Firm X Firm Y
Contribution for20,000 Units
2,00,000 2,00,000
Less:Fixed overheads1,00,000 1,50,000
EBIT 1,00,000 50,000
Operating
Leverage(Contribution orEBIT)
2,00,000/1,
00,000)= 2
2,00,000/50,0
00=4
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Analysis firm Ys operating
Leverage is twice of firm X , as thefixed overheads are higher. Thehigher the operating leverage ratio
the situation is more risky. while alow ratio indicates a largerabsorption capacity of a firm in timesof adversity.
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Disadvantages
The study of operating leveragesuffers from the following shortfalls:
(i) the reliability of operatingleverage rests to a large extent onthe correctness of the fixed costsidentified with a product. Faulty
apportionment would distort theusefulness of the ratio.
(ii) the published accounts does not
give details of the fixed cost incurred
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FINANCIAL LEVERAGE
The ratio indicates the effects onearnings by rise of fixed cost funds. Itrefers to the use of debt in thecapital structure. Financial leveragearises when a firm deploys debtfunds with fixed charge. The ratio is
expressed as follows:Financial Leverage = EBIT / EBT
The higher the ratio, the lower the
cushion for paying interest on
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DEGREE OF FINANCIALLEVERAGE
% change in EPS
= ____________________
% change in EBIT
or
% EPS
________
% EBIT
OR
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EPS can be ascertained as below:
EPS = (EBIT I )(I t) Dp
___________________
NThe degree of financial leveragemeasures the responsivess of EPS tochange in EBIT. Degree of financialleverage can also be expressed asfollows:
DFL = EBIT
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Where, DFL = Degree of financial
leverageEBIT = Earnings before Interest andTax
I = Interest on long term debtt= Corporate income tax rate
Dp = Preference Dividend
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Illustration :6.2
The following information is availablefor Crompton Ltd., for the year ended31st March 2009.
Interest on debt Rs. 4,00,000
Preference dividend Rs.2,00,000
Corporate tax rate 40%Calculate the degree of financialleverage
(i) If EBIT is Rs.10,00,000 and (ii) if
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Solution:
(i) DFL if EBIT is Rs. 10,00,000
10,00,000
=_________________________________
0,00,000 4,00,000
[2,00,000/1 0.40] = 3.75(ii) DFL if EBIT is RS.15,00,000
15,00,000
=
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Total Leverage
Total leverage may be defined as thepotential use of fixed costs, bothoperating and financial , whichmagnifies the effect of sales volumechange on the EPS of the firm. Thetotal leverage is also called as
combined leverage. The methods ofproduction employed which arereflected in the asset structure of thefirm , influence its operating leverage.
For example, substituting machinery
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For example, substituting debt forcommon stock holders equity increasesfinancial leverage. Degree of totalleverage can be calculated as follows:
DTL = Operating Leverage xFinancial Leverage
or = Contributionx EBIT
________________ _____
EBIT
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Substituting the value of EPS, we get:
DTL = Q (P V)
_____________________
Q(P V) F I DP
____
1 t
Where, Q = Quantity produced and sold
P = Selling price per unit
I = Interest cost on debt
t = Income- tax rate
V = Variable cost per unit
F = Fixed operating cost
Dp = Preference dividend
DTL measures the sensitivity of EPS to change in quantityproduced and sold.
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Illustration 6.4
Consider the following information forWatson Ltd.
Selling price per unitRs. 200
Variable cost per unit
Rs. 120Fixed cost Rs.20,00,000
Interest on debt Rs.
12,00,000
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Solution
DTL = 1,20,000 (200 120)
[ 1,20,000 ( 200 120)] 20,00,000 12,00,000 8,00,000
( 1 0.40)
= 96,00,000
96,00,000 20,00,000 12,00,000 13,33,333 =96,00,000
5 0,66,667 = 1.89
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Operating
FinancialEffect/Conclusion
LeverageLeverage
(1)High High
Very risky, High
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Illustration :6.2
The following information is availablefor Crompton Ltd., for the year ended31st March 2009.
Interest on debt Rs. 4,00,000
Preference dividend Rs.2,00,000
Corporate tax rate 40%Calculate the degree of financialleverage
(i) If EBIT is Rs.10,00,000 and (ii) if
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Solution:
(i) DFL if EBIT is Rs. 10,00,000
10,00,000
=_________________________________
0,00,000 4,00,000
[2,00,000/1 0.40]= 3.75
(ii) DFL if EBIT is RS.15,00,000
15 00 000