Amity Business School

Amity Business School

Semester II
FINANCIAL MANAGEMENT
(Leverage Analysis)

1
 What is Leverage? Amity Business School

Leverage reflects the responsiveness or influence of one

financial variable over some other financial variable.

% Change in dependent variable

Degree of Leverage =
% Change in independent variable

*The two variables, for which the relationship is to be established

and measured, should be interrelated, otherwise, the leverage study
may not have any useful purpose
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In Finance, leverage refers to the use of fixed

costs to magnify the potential return to a firm

Types of fixed costs:

Fixed Operating costs e.g.- rent, depreciation
Fixed Financial costs e.g.- interest costs on long
term debt
(Debentures) ; Preference Dividend
Total Fixed Cost Sum total of the above two
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Classification of Leverage

Just as fixed costs may be broadly classified into:

Operating Fixed Cost; and

Financial Fixed Cost,
Total Fixed Cost

Likewise, leverage may be classified into:

Operating Leverage
Financial Leverage
Combined Leverage / Total Leverage
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Sales Revenues (S) EBIT

- Variable Cost (V) - Interest

Contribution (PBT) Profit Before Tax

- Fixed Cost (F) - Tax

EBIT (PAT) Profit After Tax

- Preference Dividend
Earnings available for equity
shareholders
EPS = Earnings available for
equity shareholders
No. of Shares
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When Sales level increases or decreases, the EBIT

also changes.

The Operating Leverage measures the

relationship between the sales revenue and the
EBIT.
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Degree of Operating Leverage

The degree of operating leverage (DOL) can be

calculated as:

% EBIT %inDependen tVariable

DOL
% Sales %inIndepend entVariable
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Operating leverage is also calculated as:-

Contribution
Operating Leverage =
EBIT
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Whenever, there is a change in the level of activity and
Operating Leverage is to be found out, then use the formula-

% EBIT
DOL
% Sales

But, whenever Operating Leverage is to be found out for status-

quo or for the current level of activity then use the formula
Contribution
Operating Leverage (OL) =
EBIT
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Calculate Operating Leverage from the following data-

Particulars Base Level New Level

1. Units sold 1,000 1,100
2. Sales price per unit Rs 10 Rs 10
3. Variable cost per unit 6 6
4. Fixed operating cost Nil Nil
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Solution
EBIT for Various Sales Volume
Particulars Base Level New Level
Sales revenues Rs 10,000 Rs 11,000
Less: Variable costs (6,000) (6,600)
Less: Fixed costs
EBIT 4,000 4,400

DOL = ( 400 / 4000 ) x ( 10,000 / 1,000 ) = 1

There is no operating leverage.

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Operating leverage exists only when there are fixed operating

costs.
If there are no fixed operating costs, there will be no operating
leverage.
Conclusion;

Analysis of operating leverage of a firm is very useful to the financial manager.

It tells the impact of change in sales on the level of operating profits of the firm.

A firm with high DOL can experience a magnified effect on EBIT for even a
small change in sales Level.

Higher DOL can dramatically increase the operating profit.

But if sales decline ????????

Therefore the firms should always try to avoid operating under high DOL
as high DOL Condition is a high risk situation.
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Q1. Calculate the operating Leverage from the following data:

Sales $50000
Variable Cost 60%
Fixed Costs $12000.

Q2. Calculate & interpret the Degree of Operating Leverage

Particulars Amount ($)
Sales 1050000
Variable Cost 767000
Fixed Cost 75000
EBIT 208000
Interest 110000
Taxes (30%) 29400
Net Income 68600
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Q3. Calculate the operating leverage & interpret the result:

2010 2011
Sales 1000 units 1100 units
Sp per unit $10 $10
Variable cost per unit $6 $6
Fixed Cost Nil Nil

Q4. Calculate the operating Leverage from the following information:

Sales 1000 units 1400 units

Variable cost $7 per unit $7 per unit
Fixed cost $1000 $1000
Selling price per unit is $10.