JYOTI BARIKROLL NO : 16DM041

CONTENT

IntroductionTypes of leverageExampleConclusion

INTRODUCTION

• In financial management, the term “leverage” is used to describe the firm’s ability to use fixed cost assets or funds to increase the return to it’s owners.

• James Horne has defined leverage as “the employment of an asset or sources of funds for which the firm has to pay a fixed cost or fixed return.”

TYPES OF LEVERAGE

1. Operating leverage2. Financial leverage3. Combined leverage

OPERATING LEVERAGE• When a firm utilizes fixed cost bearing assets, in its operational

activities in order to earn more revenue to cover its total costs is known as Operating Leverage.• It can also be defined in terms of degree of operating

leverage(DOL). DOL= Percentage change in EBIT Percentage change in sales• Low DOL is preferred because it leads to low business risk.

FINANCIAL LEVERAGE

• When a company uses debt funds in its capital structure having fixed financial charges, it is said that the firm employed financial leverage.• It involves the use of funds obtained at a fixed cost in the hope of

increasing the return to the shareholders .• It can also be defined in terms of degree of financial leverage(DFL). DFL= percentage change in EPS Percentage change in EBIT• High DFL is suitable as it leads to low financial risk.

COMBINED LEVERAGE

• By using operating leverage and financial leverage , a small change in sales is magnified into a larger change in earnings per share . This “multiplier effect” is called degree of Combined Leverage.• Degree of combined leverage(DCL) can be calculated as

Percentage change in earning per share Percentage change in sales OR DOL * DFL

Example

Amount(Rs.) Amount(Rs.)Sales 100 120Variable cost (40) (48)Fixed cost (30) (30)EBIT 30 42Interest (10) (10)Tax(50%) (10) (16)PAT 10 16EPS 2 3.2

DOL= %change in EBIT = 40 = 2 DCL= DOL * DFL = 2*1.5 = 3 %change in sales 20DFL= %change in EPS = 60 = 1.5 % change in EBIT 40

Operating leverage

Financial leverage

2015 2016

CONCLUSION

OPERATING LEVERAGE

FINANCIAL LEVERAGE

EFFECT

High High Very risky. High interest outflow.

High Low Sales still unsatisfactory in relation to fixed cost to be absorbed.

Low High Ideal situation for profit maximization.

Low Low Management over cautious.