Types of leverages

The types of leverages

1. TYPES OF LEVERAGES BY ASWATHY JAYAN

2. LEVERAGE ‘Leverage’ means ‘effectiveness’ or ‘power’ A firm is said to be leveraged if it has fixed cost Degree of leverage -Measure of how much leverage the firm uses There are three types of leverages -Operating leverages -Financial leverages -Combined leverages

3. Operating leverage Operating leverage is a measurement of the degree to which a firm incurs a combination of fixed and variable cost Operating leverage = contribution/EBIT contribution = sales – variable cost EBIT = contribution –fixed cost Note : in case the contribution exceeds the fixed cost,the operating leverage is favorable. when C<F, the operating leverages is unfavorable

4. Degree of operating leverage It measures how muchis the effect of change in sales on operating profit. The degree of operating leverage at any level is expressed in percentage change in operating profit to percentage change in sales Degree of operating leverage= % change in EBIT % change in sales

5. Importance of operating leverages Profit planning Capital structure planning Risk analysis

6. Financial leverage It is the tendency of the residual net income to vary disproportionately with the operating profit. It indicate the changes that takes place in the taxable income as a result of the change in the operating profit. Financial leverage= EBIT EBT EBIT= Earning before interest and tax EBT= I-EBIT , ie earning before tax I = interest and preference divident

7. Degree of financial leverage The degree of financial leverage is defined as the percentage change in EPS due to the given percentage change in EBIT. DFL = % change in EPS % change in EBIT

8. Limitations of financial leverages Increases risk Beneficial only to companies having stable earning Restrictions from financial institutions

9. Difference between Operating leverage & Financial Leverage It establishes the relationship b/w operating profit & sales It influence EBIT It is concerned with investment decision It explains business risk of the firm It is the first stage leverage It establishes the relationship b/w operating profit & rate of equity It affect EAT It is concerned with finance decision It deals with financial risk of the firm It is the second stage leverage

10. Combined or Total leverage It is the combination of operating and financial leverage Both of these leverage are closely concerned with firms capacity to meet its fixed cost & their combined effect will measure the firms financial strength. Combined leverage = operating leverage * financial leverage

11. Degree of combined leverage It is calculated by multiplying the DOL and the DFL and it is calculated by the formula Degree of combined leverage =DOL * DFL ie ,= % change in EPS % change in sale