leverages

Suresh T SII PG M.Com

1

FINANCIAL MANAGEMENT

LEVERAGES

The dictionary meaning of the firm leverages refers to

"an increase means of accomplishing purpose".

In machines, leverages means the instrument that helps

us in lifting heavy objects, which may not be other wise

possible.

Tuesday, May 2, 2023 [email protected] 2

LEVERAGE

In financial Management the term ‘Leverage’ is used to describe the firms ability to use fixed cost assets or funds to magnify the return to its owners.

James Horne defines leverage as; “The employment of an asset or source funds for which the

firm pays a fixed cost or a fixed return”

In business language, if a firm has fixed expenses in P/L account or debt in capital structure, the firm is said to be levered.

LEVERAGE IN THE AREA OF FINANCEFINANCE


There are 3 types of leverages Viz;1.Operating Leverage2.Financial Leverage3.Composite Leverage

The leverage associated with the employment of fixed cost asset is

referred to as operating leverage, While the leverage resulting from

the use of fixed cost/return source of fund is known as financial

leverage. Composite leverage focus on the entire income of the

concern.


TYPES OF LEVERAGES

Operating leverage may be defined as the tendency of the operating profit(EBIT) to vary disproportionately with sales. Operating leverage is said to exist when a firm has to pay fixed cost regardless the volume of output or sales.

Operating leverage in a firm is a function of 3 factors 1. The amount of Fixed cost 2. The Contribution margin (S-V) 3. The volume of sales


OPERATING LEVERAGE


OPERATING LEVERAGE CONTD…

Operating Leverage = Contribution OP

Degree of OL = % Change in profits %change in sales

Operating leverage increases with fixed cost. Operating profit

of a highly levered firm would increase at a faster rate for

any given increase in sales. However if sales fall, the firm

with a high operating leverage would suffer more loss than

the firm with no or low operating leverage. hence it is said

that operating leverage is a double edged sword.


OPERATING LEVERAGE IS A ‘DOUBLE EDGED SWORD’

Profit fluctuations occurring due to high fixed cost are referred to as operating risk. Operating leverage is an important determinant of operating risk.


OPERATING RISK

Financial leverage may be defined as the tendency of the residual net

income (PBT) to vary disproportionately with operating profits

(EBIT).

It indicates the change that takes place in the taxable income as a

result of a change in the operating income.

It signifies the existence of fixed interest and or fixed dividend

bearing securities in the total capital structure of the company.


FINANCIAL LEVERAGE

In other words the use of fixed interest or dividend bearing securities

such as debt and preference capital along with the owners equity in

the total capital structure of the company is defined as financial

leverage.

Favorable financial leverage

Unfavorable financial leverage


FINANCIAL LEVERAGE CONTD…

The use of fixed charges sources of fund such as debt and

preference capital along with the owners equity in the

capital structure is called trading on equity or financial

leverage or gearing


TRADING ON EQUITY / GEARING

Financial leverage = Operating Profit(EBIT) Taxable Income (PBT)

Degree of FL = % change in taxable income % change in operating profit


FINANCIAL LEVERAGE CONTD…

Operating Leverage Financial LeverageOperating leverage is concerned with investment activities of the firm.

Financial leverage is concerned with financing activities of the firm.

It is the firm’s ability to use fixed operating costs to magnify the effects of changes in sales on its earnings before interest and taxes.

It is the firm’s ability to use fixed financial charges to magnify the effects of changes in EBIT on tis earnings per share

It is determined by the cost structure of the firm.

It is determined by the capital structure of the firm.

The higher the proportion of fixed operating costs to the total operating costs in the cost structure of a firm, the higher is the degree of operating leverage

The higher the proportion of fixe charges bearing capital to total financial changes in the capital structure of a firm, the higher is the degrees of financial leverage.

Degree of operating leverage measure the business risk associated with the firm

Degree of financial leverage measure the degree of financial risk, associated with the firm.


DIFFERENCE BETWEEN FINANCIAL LEVERAGE AND OPERATING LEVERAGE

Combined leverage is the leverage obtained by combining operating

leverage and financial leverage. Composite leverage discloses the

effect of change in sales on taxable profit ie; EPS

Composite leverage expresses the relationship between revenue on

account of sales (ie; contribution) and taxable income. It helps in

finding out the percentage change in taxable income on account of

percentage change in sales.


COMBINED LEVERAGE/ COMPOSITE LEVERAGE

Combined leverage = OL * FL

Contribution PBT


COMBINED LEVERAGE CONTD…

leverages

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