Leverage

Leverage

1. leverageleverage
Leverage in terms of financial analysis is
the influence which an independent
financial variables has over a
dependent/related variable

2. LEVERAGE ANALYSIS
• There are two kinds of leverage, viz., operating leverage and
financial leverage.
• Operating leverage arises from the firm’s fixed operating
costs.
• Financial leverage arises from the firm’s fixed financing
costs.

3. INCOME STATEMENT FORMAT
Ó Centre for Financial Management , Bangalore

Sales
Operating Less: Variable costs
leverage Less: Fixed operating costs
Contribution before interest and tax
Less: Interest on debt Total
Profit before tax leverage
Financial Less: Tax
leverage Profit after tax
Less: Preferred dividend
Equity earnings

4. Cont…Cont…
Operating leverage affects a firm’s business
risk.
Financial leverage affects a firm’s finacial
risk

5. CERTAIN RELATIONSHIPS
Ó Centre for Financial Management , Bangalore
PBIT=Q (P – V) – F
PAT=(PBIT – I) ( 1 – T)
EPS=
(PBIT – I) (1 – T) – D
p
N
=[Q (P – V) – F – I] (1 – T) – D
p
N

6. OPERATING LEVERAGE
The sensitivity of profit before interest and taxes (PBIT) to changes in unit sales is referred
to as the degree of operating leverage (DOL).
It examines the effect of change in the quantity produced on the EBIT of the company
DOL=
Δ PBIT/PBIT
Δ Q / Q
=
Q (P – V)
=
Contribution
Q (P – V) – F Profit before interest and
tax

7. FINANCIAL LEVERAGE
The sensitivity of profit before tax (or profit after tax or earnings per share) to
changes in PBIT is referred to as the degree of financial leverage.
It measures the effect of the change in EBIT on the EPS of the company
Ó Centre for Financial Management , Bangalore
DFL=
Δ EPS / EPS PBIT
=
Δ PBIT / PBITPBIT – I – DP/(1 –T)
=
Profit before interest and tax
Profit before tax

8. TOTAL LEVERAGE
The sensitivity of profit before tax (or profit after tax or earnings per share) to changes in
unit sales is referred to as the degree of total (or combined) leverage (DTL).
It is the measure of the output and the EPS of the company.
DTL=
Δ EPS /EPS Q (P – V)
=
Δ Q / Q PBIT – T
=
Contribution
Profit before tax
DTL=DOL x DFL

9. Why entire debt in capital Why entire debt in capital
structure is not suitablestructure is not suitable
when the company becomes more
financially leveraged , it becomes riskier i.e
increased use of debt financing will lead to
increased financial risk which leads to
a. increased fluctuations in return on equity
b. increase in the interest rates on debts.

10. Overall breakeven point for DTLOverall breakeven point for DTL
The overall break even point is that level of output at which DTL will
be undefined and EPS is equal to zero.
 Q = F+I+DP/(1 – t)/(S – V)
 The DTL is unique for every level of output
 At the overall break even point of output the DTL is undefined.
 If the level of output is less than the overall break even point , then

the DTL will be negative.
 If the level of output is greater than the overall break even point then
the DTL will be positive . DTL increases and reaches a limit of 1