Leverage, Types of Leverage and Valuation Concepts

According to James Horne Leverage is, the employment of an asset or fund for which the firm pays a fixed cost or fixed return”

It refers to the use of fixed cost assets to maximize the potential return for shareholders of a company. It helps to examine the debt-equity mix of a company.

Various variables which have an impact on the return of shareholders are: Cost & Revenue, Profit, Interest, Tax Rate, EBIT(Earnings before Interests and taxes) and Output. Leverage is the percentage return on shareholder equity to percentage return on rate of return of capitalization. It is expressed as:

LEVERAGE = % Change in Dependent Variable                                                                             % Change in Independent Variable 

Types of Leverage

1) Operating Leverage (OL)

It is the leverage associated with investment activities of a firm.

It refers to the ability of a firm to use its fixed and variable costs to influence sales in order to increase its operating profits or earnings before interest and taxes.

OL = Contribution/Operating Profits

Degree of Operating Leverage – It may be defined as percentage change in the profits resulting from a percentage change in the sales.

DOL = Percentage change in profits/Percentage change in sales

Operating Leverage measures the impact of change in sales of a company which lead to the change in return of shareholders or profits. Every business has a certain amount of fixed cost and variable cost associated with it. When a company spends more on employment of fixed assets and less on employment of  variable assets it is said to have a high degree of OL and vice versa. Therefore a company with a high degree of OL has a high degree of operating risk. Thus It helps to determine to position of fixed cost and variable cost of a business and measure the contribution of change in sales to increase of profits.

2) Financial Leverage (FL)

It is the leverage associated with financing activities of a firm. It is also known as trading on equity.

It refers to the ability of a firm to use long term debts and equity share capital to increase its operating profits or earning per share of shareholders. It indicates the change in Earnings before tax. It helps a firm to examine the relationship between EBIT and EPS of a firm.

A firm can increase its FL by using more financial instruments bearing fixed costs like debentures and preference share capital. A firm with a high financial leverage will see a high fluctuation in its EPS than a firm with a low financial leverage.

Financial leverage is only favourable if the firm is able to generate higher returns than the fixed financial cost. It helps a firm to take decisions regarding its capital structure.

FL = Operating profit/ Profit before tax

Degree of financial leverage – It may be defined as the percentage change in taxable profit as a result of percentage change in earnings before interest and tax (EBIT).

DFL = Percentage change in taxable Income/Percentage change in EBIT

Financial BEP is the level of EBIT which covers all fixed financing costs of the company. At this level of EBIT, EPS is equal to zero.

3) Combined Leverage (CL)

When a company makes use of both financial and operating leverage to influence its sales in order to increate profit or EPS

CL = OL x FL

CL= Contribution/Earnings before tax

Degree of Combined Leverage is the percentage change in a firm’s earning per share (EPS) to the percentage change in sales of the firm.

DCL = Percentage change in EPS/Percentage change in sales

Earnings per Share – It is the earnings of equity shareholders per share.

EPS = (EBIT-I)(1-t)

N (No. of Shares)

Indifference Point occurs at a point on which different sets of debt ratios give the same EPS.

Computation/Valuation concepts of LeverageParticularsParticularsSales (S)(-) minusVariable Cost (VC)(=) equalsContribution (C)–Fixed Cost (FC)=Operating Profit (OP)Earnings before interests and taxes (EBIT)–Interest on long term debtsInterest on debentures=Earnings Before Tax (EBT)Profit Before Tax (PBT)–Tax (%)=Earnings after Tax (EAT)Profit After Tax (PAT)=Earnings available to Equity shareholders

Operating Leverage & Financial Leverage

Leverage & Types of Leverage

Note –

  1. Interest paid to preference shareholders is not deducted from Operating Profit (OP) or Earnings before interest and taxes (EBIT)

  2. Tax is calculated on Earnings before tax (EBT) or Profit before tax (PAT)

  3. High OL implies High Business risk

  4. High FL implies high fluctuations in EPS

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