Leverages

In Financial Management the term “Leverage” is used to describe the firm's ability to use fixed cost assets or funds to increase the return to its equity shareholders.

James Horne has defined leverage as, " the employment of an asset or sources of funds for which the firm has to pay a fixed cost or fixed return."

It needs to be remembered that the fixed cost or fixed return (Interest) remains same irrespective of the level of operations.

We also need to understand that the higher degree of leverage means higher profit but also higher risk.

Broadly there are two types of leverages - 

1.  Financial Leverage, and

2. Operating Leverage

The leverage resulting from the use of fixed cost/ return sources of funds is known as Financial Leverage while the Leverage associated with employment of fixed cost assets is referred to as Operating Leverage.

Financial Leverage or Trading on Equity

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 impact of Financial Leverage can be analysed while looking at EPS (Earnings Per Share) and Return on Equity Capital.

EPS can also be calculated in a tabular form as follows –

1. Earnings Before Interest & Tax (EBIT)                   
2. Less: Interest    
3. Earnings Before Tax (EBIT - I)
4. Less: Tax @ ____% 
5. Earnings After Tax (EAT)  
6. Less: Preference Dividend
7. Earnings Available for Equity Shareholders
8. Number of Equity Shares
9. Earnings Per Share (EPS) (7 /8)

Degree of Financial Leverage (DFL)

DFL =  Percentage change in EPS

      Percentage change in EBIT

                   OR

DFL = EBIT

       EBT                EBT = EBIT - I

Operating Leverage

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 in sales.

In Simple words Operating Leverage is the change in Operating Profit due to change in Sales.

Operating Leverage =     Contribution   

                       Operating Profit

Where, 

Contribution = Sales - Variable Cost

Operating Profit = Sales - Variable Cost - Fixed Cost

                     OR

Operating Profit = Contribution - Fixed Cost

Some Additional Formulas needed are -

Break Even Point (BEP)  =  Fixed Cost

                           P/V Ratio

P/V Ratio = Contribution

              Sales