Leverages

Prof. Nidhi Bandaru

Introduction
 A firm can make use of different sources of
finance whose costs are different.
 The employment of sources of funds for

which the firm has to pay a fixed cost or fixed

return may be termed as leverage.
 If earnings less the variable costs exceed the

fixed costs, or EBIT exceed fixed return

requirement, the leverage is favorable.
 There are two types of leverages
◦ Operating Leverages
◦ Financial Leverages
 Operating Leverage is the leverage associated
with investment activities.
 Financial Leverage is the leverage associated

with financing activities.

Operating Leverage
 Operating leverage results from the existence of fixed
operating expenses in the firm’s income stream.
 The operating costs of a firm fall into three categories
◦ Fixed costs
◦ Variable costs
◦ Semi-variable costs
 Thus, the costs can broadly be classified into fixed
and variable costs
 The operating leverage can be defined as the firm’s
ability to use fixed operating costs to magnify the
effects of changes in sales on its EBIT.
 Degree of operating leverage (DOL)=
%change in EBIT/ % change in sales >1
 When the proportionate change in EBIT as a result

of a given change in sales is more than the

proportionate change in sales, operating leverage
exists.
 The greater the DOL, the higher is the operating

leverage.
 Operating leverage exists only when there are

fixed operating costs.

 Operating risk s high when leverage is high.
Financial Leverage
 Financial leverage relates to the financing activities of a
firm.
 The sources from which funds are raised can be
categorized into
◦ Fixed financial charge
◦ Variable financial charge
 Financial leverage results from the presence of fixed
financial charges in the firm’s income stream.
 Financial leverage is concerned with the effects of changes
in EBIT on the earnings available to equity holders.
 It is defined as the firms ability to use fixed financial
charges to magnify the effects of changes in EBIT on the
earnings per share.
 Favourable or positive leverage occurs when the firm
earns more on the assets purchased with the funds,
than the fixed costs of their use.
 Financial leverage is based on the assumption that
the firm is to earn more on the assets that are
acquired by the use of funds on which a fixed rate of
interest/dividend is to be paid.
 The difference between the earnings from the assets
and the fixed cost on the use of funds goes to the
equity shareholder.
 Financial leverage is also called as ‘trading on
equity.’
 Degree of financial leverage (DFL) =
%change in EPS/% change in EBIT >1
 As a rule, when a percentage change in EPS

resulting from a percentage change in EBIT,

financial leverage exists.
Combined Leverage
 Since, both the leverages are closely
concerned with ascertaining the ability to
cover fixed charges, if they are combined the
result is total leverage
 DCL = DOL * DFL
Formulae
 Financial leverage = EBIT / EBT = OP/EBT
 Operating leverage = S-V/EBIT = C/Op
 Combined leverage = C/OP * OP/EBT =

C/EBT