This article throws light upon the top three types of leverage. The types are: 1. Financial Leverage 2. Operating Leverage 3. Composite Leverage.
Type # 1. Financial Leverage:
A firm needs funds so run and manage its activities. The funds are first needed to set up an enterprise and then to implement expansion, diversification and other plans. A decision has to be made regarding the composition of funds. The funds may be raised through two sources: owners, called owners equity, and outsiders, called creditor’s equity.
When a firm issues capital these are owners’ funds, when it raises, funds by raising long-term and short-term loans it is called creditors’ or outsiders’ equity. Various means used to raise funds represent the financial structure of a firm. So the financial structure is represented by the left side of the balance sheet i.e. liabilities side.
Traditionally, the short-term finances are excluded from the methods of financing capital budgeting decisions, so, only long term sources are taken as a part of capital structure. The term capital structure’ refers to the relationship between various long-term forms of financing such as debentures, preference share capital, equity share capital, etc.
Financing the firm’s assets is a very crucial problem in very business and as a general rule there should be proper mix of debt and equity capital. The use of long-term fixed interest bearing debt and preference share capital along with equity share capital is called financial leverage or trading on equity.
The long-term fixed interest bearing debt is employed by a firm to earn more from the use of these resources than their cost so as to increase the return on owner’s equity. It is true that the capital structure cannot affect the total earnings of a firm but it can affect the share of earnings for equity shareholders.
The fixed cost funds are employed in such a way that the earnings available for common stockholders (equity shareholders) are increased. A fixed rate of interest is paid on such long-term debts (debentures, etc.). The interest is a liability and must be paid irrespective of revenue earnings. The preference share capital also bears a fixed rate of dividend.
But, the dividend is paid only when the company has surplus profits. The equity shareholders are entitled to residual income after paying interest and preference dividend. The aim of financial leverage is to increase the revenue available for equity shareholders using the fixed cost funds.
If the revenue earned by employing fixed cost funds is more than their cost (interest and/or preference dividend) then it will be to the benefit of equity shareholder to use such a capital structure. A firm is known to have a favourable leverage if its earnings are more than what debt would cost. On the contrary, if it does not earn as much as the debt costs then it will be known as an unfavourable leverage.
Every firm has to make its own decision regarding the quantum of funds to be borrowed. When the amount of debt is relatively large in relation to capital stock, a company is said to be trading on their equity. On the other hand if the amount of debt is comparatively low in relation to capital stock, the company is said to be trading on thick equity.
Type # 2. Operating Leverage:
Operating leverage results from the presence of fixed costs that help in magnifying net operating income fluctuations flowing from small variations in revenue. The fixed cost is treated as fulcrum of leverage. The changes in sales are related to changes in revenue. The fixed costs do not change with the change in sales.
Any increase in sales, fixed costs remaining the same, will magnify the operating revenue. The operating leverage occurs when a firm has fixed costs which must be recovered irrespective of sales volume. The fixed costs remaining same, the percentage change in operating revenue will be more than the percentage change is sales.
The occurrence is known as operating leverage. The degree of operating leverage depends upon the amount of fixed elements in the cost structure. Operating leverage can be determined by means of a break even or cost volume profit analysis.
The degree of leverage will be calculated as:
Operating Leverage = Contribution/Operating Profit
Contribution = Sales-Variable cost
Operating Profit = Sales – Variable Cost – Fixed cost
or O.P. = Contribution-Fixed Cost
The break-even point can be calculated by dividing the fixed cost by percentage of contribution to sales or P/V Ratio.
Break Even Point = Fixed Cost/P/V Ratio
P/V Ratio = Contribution/Sales
When production and sales move above the break-even point, the firm enters highly profitable range of activities. At breakeven point the fixed costs are fully recovered, any increase in sales beyond this level will increase profits equal to contribution. A firm operating with a high degree of leverage and above breakeven point earns good amount of profits.
If a firm does not have fixed costs then there will be no operating leverage. The percentage change in sales will be equal to the percentage change in profit. When fixed costs are there, the percentage change in profits will be more than the percentage in sales volume.
Thus, degree of operating leverage can be computed as below:
Degree of Operating Leverage = Percentage Change in Profits/Percentage change in Sales
Following is the cost information of a firm:
Fixed cost = Rs. 50,000
Variable cost = 70% of sales
Sales = Rs. 2,00,000 in previous year and Rs. 2,50,000 in current year.
Find out percentage change in sales and operating profits when:
(i) Fixed costs are not there (no leverage)
(ii) Fixed cost are there (leveraged situation).
(1) In situation (i) where there are no fixed costs (or absence of leverage) the percentage change in sales and percentage change in operating profit is the same i.e. 25%.
(2) In situation (ii) where there are fixed costs, the leverage being occurring, the percentage change in profits (150%) is much more than the percentage change is sales (25%).
(3) The fixed cost element has helped in magnifying the percentage increase in operating profits.
It is true hat a high leveraged situation will magnify the operating profits but it brings in the risk element too. The percentage change in profits will be more in a situation with higher fixed costs as comparted to that where fixed costs are lower. The higher degree of leverage brings in more decrease in operating profits. This situation can be illustrated with the help of the following illustration.
Following information is taken from the records of a hypothetical company:
Calculate operating leverage under the following situations:
A 10 per cent increase in sales would be accompanied by an increase in operating profits of 15% in situation A, 20% in situation B and 26.7% in situation C. Situation C is of high operating leverage since the operating profit will increase by one 2½ times (26.7% for every 10% increase in Sales). This is high risk situation too because a small decrease in sales will result in more decrease in profits.
The margin of safety ratio is 66.7% in situation A which means that a sales decrease of this percentage will bring the firm to break-even point (no profit no loss point). This ratio in situation C is only 37.5% which means that the company can reach the break even situation much more early as compared to situation A.
Taking the percentage of sales at break-even point; it will reach at 33.3% of sales in situation A, 50% in situation B and 62.5% in situation C. In situation A the company will start earning profit at an early stage of sales while in situation C it will reach only beyond 62.5% in situation C. In situation A the company will start earning profit at an early stage of sales while in situation C, it will reach only beyond 62.5% of sales.
A high operating leverage (situation C) has low margin of safety and has thin cushion for absorbing shocks whereas a situation of low operating leverage (situation A) has higher margin of safety ratio. This situation is less risky because any decrease in sales will not bring down the profits at a higher rate.
It can be concluded that a high leveraged situation brings in more profits with the increase in sales but at the same time it brings in more risk too.
Type # 3. Composite Leverage:
Both financial and operating leverage magnify the revenue of the firm. Operating leverage affects the income which is the result of production. On the other hand, the financial leverage is the result of financial decisions.
The composite leverage focuses attention on the entire income of the concern. The risk factor should be properly assessed by the management before using the composite leverage. The high financial leverage may be offset against low operating leverage or vice-versa.
The degree of composite leverage can be calculated as follows:
Degree of Composite Leverage (DCL) = Percentage Change in EPS/percentage Change in Sales
Or, Composite Leverage = Operating Leverage Financial Leverage
A company has sales of Rs. 5,00,000, variable costs of Rs. 3,00,000, fixed costs of Rs. 1,00,000 and long-term loans of Rs. 4,00,000 at 10% rate of interest. Calculate the composite leverage:
A simplified income statement of Zenith Ltd. is given below. Calculate and interpret its degree of operating leverage, degree of financial leverage and degree of combined leverage.
Income Statement of Zenith Ltd. for the year ended 31st March 2005:
The following figures relate to two companies:
You are required to:
(i) Calculate the operating, financial and combined leverages for the two companies; and
(ii) Comment on the relative risk position of them.
(ii) Comments on the Relative Risk Position:
(a) Operating Leverage:
As the operating leverage for Q Ltd. is higher than that of P. Ltd; Q Ltd. has a higher degree of operating risk. The tendency of operating profit to vary disproportionately with sales is higher for Q Ltd. as compared to P. Ltd.
(b) Financial Leverage:
Since finance leverage for the two companies is the same, both the companies have the same degree of financial risk, i.e. the tendency of net disproportionately is the same for P. Ltd. and Q Ltd.
(c) Combined Leverage:
As the combined leverage for Q Ltd. is higher than P Ltd; Q Ltd. has overall higher risk as compared to P Ltd.
A firm has sales of Rs. 20,00,000, variable cost of Rs. 14,00,000 and fixed costs of Rs. 4,00,000 and debt of Rs. 10,00,000 at 10% rate of interest. What are the operating, financial and combined leverages? If the firm wants to double its Earnings before Interest and Tax (EBIT), how much of a rise in sales would be needed on a percentage basis?
Rise in Sales Needed to Double its EBIT:
As the operating leverage is 3, when sales increase by 100% operating profit will increase by 300%. Thus, 33⅓% rise in sales volume will increase the operating profit by 100%), i.e., double the earnings before interest and tax.
From the following information, calculate the percentage of change in earnings per share if sales are increased by 5%:
Calculate operating leverage and financial leverage under situations 1 and 2 and financial plans A and B respectively from the following information relating to the operation and capital structure of a company. What are the combinations of operating and financial leverage which give highest and least value?
A firm has sales of Rs. 75,00,000, variable cost of Rs. 42,00,000 and fixed cost of Rs. 6,00,000. It has a debt of Rs. 45,00,000 at 9% and equity of Rs. 55,00,000.
(i) What is the firm’s ROI?
(ii) Does it have favourable financial leverage?
(iii) If the firm belongs to an industry whose asset turnover is 3, does it have a high or low asset leverage?
(iv) What are the operating, financial and combined leverages of the firm?
(v) If the sales drop to Rs. 50,00,000, what will be the new EBIT?
(vi) At what level the EBT of the firm will be equal to zero?
From the following, prepare Income Statement of company A, B and C:
Working Capital Leverage:
Working capital leverage measures the sensitivity of return on investment (ROI) of changes in the level of current assets (CA), symbolically:
WOL = Percentage Change in ROI/Percentage Change in CA
In case the earnings are not affected by the change in current assets, then working capital leverage can be simply calculated as:
WCL = CA/TA±DCA
Where, CA = Current Assets
TA = Total Assets
DCA = Change in the level of Current Assets
The following information is available for two companies:
You are required to compare the sensitivity of earnings of the two companies for a 25% change in the level of their current Assets.