Leverage analysis

Leverage Analysis In Financial Management
Leverage is the burden which arises with the presence of fixed cost in business
If a business is leveraged , it means that the firm has borrowed money to finance the purchase of assets
With larger presence of fixed cost profit margins can really get squeezed when the business scenario is not favorable and the sales fall. This adds risk to the stocks of such companies
Conversely, with the same larger presence of fixed cost company would experience magnified profits with increase in sales as the cost level remaining constant
Operating Leverage- It arises with the presence of firm’s fixed operating costs such as salaries, rent, depreciation, utility expense etc.
Financial Leverage- It arises with the presence of firm’s fixed financing costs such as interest expenses on debt and preference shares
Combined Leverage- Product of operating and financial leverage
Formulas for calculation of leverages-
Operating Leverage = Contribution / EBIT
Operating Leverage = % change in EBIT/ % change in sales
Financial Leverage = EBIT/ EBT
Financial Leverage = % change in EPS / % change in EBIT
Combined Leverage = OL * FL
Degree of Combined Leverage = % change in EPS / % change in Sales
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1. Leverage analysis FINANCIAL MANAGEMENT

2. Introduction Leverage  refer to the amount of debt a firm uses to finance assets It arises from the existence of fixed costs It is an investment strategy to use borrowed money If a business is leveraged , it means that the firm has borrowed money to finance the purchase of assets

3. Continued With larger presence of fixed cost profit margins can really get squeezed when the business scenario is not favorable and the sales fall. This adds risk to the stocks of such companies Conversely, with the same larger presence of fixed cost company would experience magnified profits with increase in sales as the cost level remaining constant

4. Magnification effect with the presence of fixed cost Case 1 Case2 Case 3 Revenue 15 lacs 21 lacs 12 lacs - Fixed Cost -10 lacs -10 lacs -10 lacs = Profit =5 lacs =11 lacs =2 lacs % Change in Revenue = Case2 (21-15)/15 * 100 = 40% Case3 (12-15)/15*100 = -20% % Change in Profit = Case2 (11-5)/5 * 100 = 120% Case3 (2-5)/5* 100 = -60%

5. Types of Leverage Operating Leverage- It arises with the presence of firm’s fixed operating costs such as salaries, rent, depreciation, utility expense etc. Financial Leverage- It arises with the presence of firm’s fixed financing costs such as interest expenses on debt and preference shares Combined Leverage- Product of operating and financial leverage

6. Formulas Sales – Variable cost = Contribution Contribution – Fixed cost = Earning before interest and tax Earning before Interest and tax – Interest = Earning before Tax Earning before tax – Tax = Earning after Tax Earning per share = Earning after Tax / No. of Shares

7. FORMULA Degree of Operating Leverage = Contribution / EBIT Degree of Operating Leverage = % change in EBIT/ % change in sales Degree of Financial Leverage = EBIT/ EBT Degree of Financial Leverage = % change in EPS / % change in EBIT Degree of Combined Leverage = OL * FL Degree of Combined Leverage = % change in EPS / % change in Sales

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