TYPES OF LEVERAGES

BYASWATHY JAYAN

LEVERAGE ‘Leverage’ means ‘effectiveness’ or ‘power’A firm is said to be leveraged if it has fixed

costDegree of leverage -Measure of how much leverage the firm

uses There are three types of leverages -Operating leverages -Financial leverages -Combined leverages

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 costNote : in case the contribution exceeds

the fixed cost,the operating leverage is favorable. when C<F, the operating leverages is unfavorable

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

Importance of operating leverages

Profit planning Capital structure planning Risk analysis

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 EBTEBIT= Earning before interest and taxEBT= I-EBIT , ie earning before taxI = interest and preference divident

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

Limitations of financial leverages

Increases risk Beneficial only to companies having

stable earning Restrictions from financial

institutions

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

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

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