leverage - icai knowledge · pdf filefl = financial leverage ebit =earning before interest and...

LeverageBusinessRisks&FinancialRisks

Paper2:FinancialManagementUnit3ofChapter4

Navin Khandelwal FCA, DISA1

Synopsis Concept of Leverages. Definition. Types of leverages. Operating  Leverage.    Importance of Operating Leverage.

Financial leverage. Importance of Financial Leverage.

Combined Leverage Graded Illustrations from past CA Exams Pr

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LeverageAn Intro.

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ConceptofLeverageLeverage refers to –Relationship between two inter related variables.

It represents  ‐The influence of one financial variable over some other  related financial variable.

DEFINITION ;% change in one variable  divided by the % change in some other variable.

= % change in dependent variable% change in independent variable

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LeverageTypesAn Intro.

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LeverageTypes

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TypesTypes

OperatingOperating FinancialFinancial CombinedCombined

OperatingLeverage(OL)An Intro.

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Definition

The firm’s position or ability to magnify the effect of change in sales over the level  of Earnings Before Interest and Tax (EBIT)

OR 

Employment of an asset with a fixed cost in the hope that sufficient revenue will be generated to cover all the Fixed and Variable costs.

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Relationship

Measures the relationship between the sales revenue  and EBIT.

OL = C / EBIT 

OL =   %  change in EBIT  % change in Sales Revenue 

EBIT = Earning before interest and taxes or :( Contribution ‐ Fixed Costs)

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GreaterBusinessRiskwithGreaterOperatingLeverageHigher Operating Leverage leads to more Business  Risk

A Small Sales decline causes a larger Profit decline

As in our example we see % inc in Sales is 10% % inc in EBIT is 12.5% So our OL is 1.25 Now if we assume that our OL is higher Say 4Then 10% Change in Sales can cause 40%  (4 x 10 )change in EBIT i.e. increase & decrease in both ways

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ImportanceofOL

A firm should always try to avoid operating under high DOL..Under good economic condition a high OL are favorable for thefirm but under bad economic condition a high OL is notpreferred for the firm.

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OperatingLeverageIllustration 1

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Illustration1(A)‐Shahrukh Khan Ltd. has the following details related to Sales, Variable Cost & Fixed Costs. Calculation of EBIT & OL has been Shown below.

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Particular Amount (Previous year)

Amount (Current year)

Change/Difference

Change in %

Sales  10,00,000 11,00,000 1,00,000 10%

Variable Cost 5,00,000 5,50,000 50,000 10%

Contribution 5,00,000 5,50,000

Fixed Cost 1,00,000 1,00,000 0 0

EBIT 4,00,000 4,50,000 50,000 12.5%

OL =12.5%/10%=1.25

Illustration1(B)‐Shahrukh Khan Ltd. has the following details related to Sales, Variable Cost & Fixed Costs. Calculation of EBIT & OL has been Shown below.

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Particular Amount (Previous year)

Sales  10,00,000

Variable Cost 5,00,000

Contribution 5,00,000

Fixed Cost 1,00,000

EBIT 4,00,000

OL =5,00,000/4,00,000=1.25

FinancialLeverage(FL)An Intro.

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FLmeans...

•Use of funds with a fixed cost in order to increaseEPS (earning per share).

•Use of companies funds in which it pays a limitedreturn.

•Use of fixed cost funds in such a way to increase thereturn on shareholders funds.

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Definition‐ FL

FL = % change in EPS

% change in EBIT

The existence of fixed financing charge is instrumental tobring this magnifying effect and also determines the extentof this effect. Pr

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CalculationofFinancialLeverage

FL = EBIT / EBTor

FL = EBIT / EBIT-I-PD/(1-T)Where : FL = Financial leverageEBIT =Earning before interest and taxesEBT = Earning before taxes = EBIT – INTEREST PD=Preference DividendT=Tax Rate

FinancialLeverageIllustration 2

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Illustration2(A)‐Salman Khan Ltd. has the following details related to Sales, Variable Cost & Fixed Costs. Calculation of EBIT, EPS & FL has been Shown below.

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Particular Amount (Previous year)

Amount (Current 

year)

Change/Difference

Change in %

Sales  10,00,000 11,00,000 1,00,000 10%

Variable Cost 5,00,000 5,50,000 50,000 10%

Fixed Cost 1,00,000 1,00,000 0 0

EBIT 4,00,000 4,50,000 50,000 12.5%

EPS 10 12 2 20%

FL =20%/12.5%=1.6

Illustration2(B)‐Salman Khan Ltd. has the following details related to Sales, Variable Cost & Fixed Costs. Calculation of EBIT, EBT & FL has been Shown below.

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Particular Amount (Previous year)

Sales  10,00,000

Variable Cost 5,00,000

Fixed Cost 1,00,000

EBIT 4,00,000

Interest 2,00,000

EBT 2,00,000

FL =4,00,000/2,00,000=2

ImportanceofFinancialLeverage

• Higher the level of fixed financial charge, greater would be theFL.

• The changes in EPS would be at a higher rate than thechanges in EBIT.

• The advantage arises from the possibility that funds borrowedat a fixed interest rate can be used for investmentopportunities earning a rate of return higher than the interestpaid. Pr

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CombinedLeverage(CL)An Intro.

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Definition&Formula• Potential use of fixed costs, both operating and

financial, which magnifies the effect of sales volume on the earning per share of the firm

= % Change inEPS% Change in sales

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CombinedLeverage

• OL explains           the business risk complexion.

• FL explains            the financial risk  of the firm.

• CL explains             the overall risk of the firm.

• Thus ,   CL = OL X FL

CL = Cont / EBT

CombinedLeverageIllustration 3

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Illustration3‐Amir Khan Ltd. Has Following OL & FL . We can Calculate the Combined Leverage for it as follows

OL= 1.25

FL= 0.5

CL= 1.25 x 0.5 = 0.625

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PastExaminationProblemsonLeverages

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Illustration4

Operating, Financial & Combined Leverage

CA PE‐II, Nov 2002

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ProblemStatement

The data relating to two companies are as given below :Particulars                                                   Company A Company BCapital                                        6,00,000  3,50,000Debentures 4,00,000  6,50,000Output (Units) Per Annum 60,000 15,000Selling Price/ Unit 30 250Fixed Cost Per Annum 7,00,000  14,00,000Variable Cost / Unit 10  75You are required to calculate the Operating leverage , Financial Leverage , Combined Leverage of two Companies. (Ans ;DOL 2.4,2.14 , DFL 1.11 , 1.07 , DCL 2.66 , 2.29 )

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Illustration5

Operating, Financial & Combined Leverage

CA (Nov – 2004)

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ProblemStatementThe following summarizes the % changes in operating income,% changes in revenues for pharmaceutical firms.

Change in Revenue Change in Operating IncPQR Ltd 27% 25%RST Ltd 25% 32%TUV Ltd 23% 36%WXY Ltd 21% 40%Required :Calculate the degree of Operating Leverage for each of these firms.Comment also.

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Illustration6

Operating, Financial & Combined Leverage

CA (May – 2008)

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ProblemStatementThe following data relate to RT Ltd :

RsEarning before interest and tax (EBIT)                            10,00,000Fixed cost                                                                             20,00,000Earning Before Tax(EBT)                                                       8,00,000Required :Calculate Combined Leverage.

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Illustration7

Operating, Financial & Combined Leverage

CA (Nov – 2009)

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ProblemStatementFrom the following Financial data of Company A and Company B. Prepare their Income Statements.

Company A                 Company BVariable cost                   56,000                       60% of salesFixed cost                        20,000                            ‐Interest expenses          12,000                        9,000Financial Leverage          5:1                                ‐Operating  Leverage          ‐ 4:1Income tax rate                30%                           30%Sales                                    ‐ 1,05,000

(Ans : EAT A – 2100, B‐ 1050)

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Illustration7

Operating, Financial & Combined Leverage

CA (Nov – 2008)

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ProblemStatementA Company operates at a production level of 1,000 units. Thecontribution is Rs 60 per unit, operating leverage is 6, combinedleverage is 24. If tax rate is 30% , what would be its earningsafter tax ?

(Ans : Rs 1750)

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Illustration8

Operating, Financial & Combined Leverage

CA (Nov – 2007)

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ProblemStatementAnswer the following :A firm has Sales of Rs 40 lakhs ; Variable cost of Rs 25 lakhs ;Fixed cost of Rs 6 lakhs ; 10% debts of Rs 30 lakh ; and EquityCapital of Rs 45 lakhs.

Required :Calculate operating and financial leverage.

(Ans : OL 1.67, FL 1.50)

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ThankYou

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