Types of Leverage

Types of Leverages
Operating leverage arises from the existence of fixed operating costs such as salary, rent, utilities etc.
A company with high fixed cost and low variable cost has high operating leverage whereas, a company with low fixed cost and high variable cost has low operating leverage.
Operating leverage magnifies both profit as well as loss .
When the sales increases profit will be magnified, when the sales decreases loss also will be magnified.
Financial leverage is the degree to which a company uses fixed interest expense securities such as debt and preference shares
The more debt financing a company is in higher financial leverage.
A high degree of financial leverage means high interest payments which negatively affect the company's bottom line earnings per share
Degree of operating leverage will tell how much is the risk related to the operating activities
Degree of financial leverage will tell how much is the risk related to the financial activities
Combined leverage takes into consideration the overall leverage including operating and financial leverage
Formulas-
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
Thank you for watching
Subscribe to DevTech Finance for more videos.

1. TYPES OF LEVERAGE Financial Management

2. Types of Leverage Operating Leverage Financial Leverage Combined Leverage

3. 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

4. FORMULAs 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

5. NUMERICAL eXAMPLE – Calculate dEgree of operating, financial and combined leverages Particulars Values Units 50000 Fixed Cost $10000 Variable cost per unit $ 0.20 Interest Expense $ 2000 Selling Price per unit $ 0.50

6. SOLUTION Sales = No. of units * Selling price per unit 50000* 0.50 = $ 25000 Variable cost = No. of units * Variable cost per unit 50000*0.20 = $10000

7. Degree of operating Leverage Degree of Operating Leverage = Contribution / EBIT Contribution= Sales – Variable Cost= 25000-10000=15000 EBIT= Sales – (Variable cost + Fixed cost) = 25000- (10000+10000) = 5000 DOL = 15000 / 5000 = 3

8. Degree of financial leverage Degree of Financial Leverage = EBIT/ EBT EBIT = 5000 EBT = EBIT – Interest Expenses= 5000- 2000=3000 DFL = 5000/3000 = 1.67

9. Degree of combined leverage Degree of Combined Leverage = D OL * DFL DCL = 3 * 1.67 = 5.01 Interpretaion - The business is more leveraged because of the presence of fixed operating cost where the degree of operating leverage is 3, higher as compared to the financial burden of 1.67

10. Using the percentage formula Suppose with the same data given if you are required to find- % change in EPS if EBIT increases by 5% % change in EBIT if sales increases by 10% % change in EPS if sales increases by 10%

11. Solution 1. Degree of Financial Leverage = % change in EPS / % change in EBIT => % change in EPS = DFL * % change in EBIT = 1.67 * 5 = 8.35% 2. Degree of Operating Leverage = % change in EBIT/ % change in sales => % change in EBIT = DOL* % change in sales = 3 * 10 = 30% 3. Degree of Combined Leverage = % change in EPS / % change in Sales => % change in EPS = DCL * % change in Sales = 5.01 * 10 = 50.1%

12. THANK YOU FOR WATCHING DevTech Finance