Study Note - 4
LEVERAGE
Analysis of Operating and Financial Leverages
This Section includes :
Concept and Nature of leverages operating risk and financial risk and
combined leverage.
Operating leverages and CVP analysis and EPS, indifference point.
INTRODUCTION :
The concept of leverage has its origin in science. It means influence of one force over another.
Since financial items are inter-related change in one causes change in profit. In the context of
financial management, the term ‘leverage’ means sensitiveness of one financial variable to
change in another. The measure of this sensitiveness is expressed as a ratio and is called
degree of leverage.
Algebrically, the leverage may be defined as,
Leverage =%Change in one variable/%Change in some other variable
CONCEPT AND NATURE OF LEVERAGES OPERATING RISK AND FINANCIAL
RISK AND COMBINED LEVERAGE :
Measures of Leverage
To understand the concept of leverage, it is imperative to understand the three measures of
leverage
(i) Operating Leverage
(ii) Financial Leverage
(iii) Combined Leverage
In explaining the concept of leverage, the following symbols and relationship shall be
used :
Number of units produced and sold = Q
Sale Price per unit = S
Total Sale Value or Total Revenue = SQ
Variable Cost per unit = V
Total Variable Cost = VQ
Total Contribution = Total Revenue – Total Variable Cost
=SQ – VQ
= Q (S–V)
Contribution per unit= Total Contribution/Units sold
=Q(S-V)
= S − V = C
Earning before Interest and Tax = EBIT
= Total Contribution – Fixed Cost
If, Fixed Cost = F
Then, EBIT = Q (S – V) – F
= CQ – F. ( Here, CQ denotes contribution)
Operating Leverage
It is important to know how the operating leverage is measured, but equally essential is to
understand its nature in financial analysis.
Operating leverage reflects the impact of change in sales on the level of operating profits of
the firm.
The significance of DOL may be interpreted as follows :
Other things remaining constant, higher the DOL, higher will be the change in EBIT for
same change in number of units sold in, if firm A has higer DOL than form B, profits of
firm A increase at faster rate than that of firm B for same increase in demand.
This however works both ways and so losses of firm A increase at faster rate than that of
firm B for same fall in demand. This measns higher the DOL, more is the risk.
DOL is high where contribution is high.
There is an unique DOL for each level of output.
Operating Leverage examines the effect of the change in the quantity produced on the EBIT
of the Company and is measured by calculating the degree of operating leverae (DOL)
The degree of operating leverage is therefore ratio between proportionate change in EBIT
and corresponding proportionate change in Q.
Thus DOL
Q Q
EBIT EBIT
/
/
Δ
= Δ
Putting, EBIT = CQ – F in above equation, we get
EBIT
Contribution
CQ F
CQ
DOL =
−
=
Leverage
Financial Leverage
The Financial leverage may be defined as a % increase in EPS in associated with a given
percentage increase in the level of EBIT. Financial leverage emerges as a result of fixed financial
charge against the operating profits of the firm. The fixed financial charge appears in case
the funds requirement of the firm are partly financed by the debt financing. By using this
relatively cheaper source of finance, in the debt financing, the firm is able to magnify the
effect of change in EBIT on the level of EPS.
The significnace of DFL may be interpreted as follows :
Other things remaining constant, higher the DFL, higher will be the change in EPS for
same change in EBIT. In other words, if firm K has higher DFL than firm L, EPS of firm K
increase at faster rate than that of firm L for same increase in EBIT. However, EPS of firm
K falls at a faster rate than that of firm K for same fall in EBIT. This means, higher the DFL
more is the risk.
Higher the interst burden higher the DFL, which means more a firm borrows more is its
risk.
Since DFL depends on interest burden, it indicates risk inherent in a particular capital mix,
and hence the name financial leverage.
There is an unique DFL for each amount of EBIT.
While operating leverage measures the change in the EBIT of a company to a particular
change is the output, the financial leverage measures the effect of the change in EBIT on the
EPS of the company.
Thus the degree of financial leverage (DEL) is ratio between proportionate change in EPS
and proportionate change in EBIT.
Here,
N
EBIT I I T D
EPS
= − − − ( ) ( )
Where I = Interest
t = Tax rate
D = Preference Dividend
N = No of equity shares.
EBIT EBIT
EPS EPS
DFL
/
/
Δ
= Δ
Substituting the value of EPS above, we have
(EBIT - I) (I - t) -D
EBIT (1 - t)
DEL
It there is no preference share capital,
then
EBIT I
EBIT
DEL
−
=
Earning after interest
Earning before interest and tax
=
Combined Leverage
The operating leverage explains the business risk of the firm whereas the financial leverage
deals with the financial risk of the firm. But a firm has to look into the overall risk or total of
the firm, which is busines risk plus the financial risk.
One can draw the following general conclusion about DCL.
Other things remaining constant, higher the DCL higher will be the change in EPS for
same change in Q (Deamand).
Higher the DCL, more is the overall risk, and higher the fixed cost and interest burden in
lower the earning after interest, higher is the DCL.
There is an unique DCL, for each level of Q.
A combintation of the operating and financial leverages is the total or combination leverage.
The operating leverage causes a magnified effect of the change in sales level on the EBIT level
and if the financial leverage combined simultaneously, then the change in EBIT will, in turn,
have a magnified effect on the EPS. A firm will have wide fluctuations in the EPS for even a
small change in the sales level. Thus effect of change in sales level on the EPS is known as
combined leverage.
Thus Degree of Combined leverage may be calculated as follows :
Change in Sales
% Change in EPS
DCL
%
=
Q Q
EPS EPS
/
/
Δ
= Δ
It measures sensitively of EPS to change in Q. It is not a distinct type of leverage analysis, it is
product of the operating leverage and financial leverage.
in
Q Q
EPS EPS
DCL
/
/
Δ
= Δ
Q Q
EBIT EBIT
EBIT EBIT
EPS EPS
/
/
/
/
Δ
× Δ
Δ
= Δ
= DFL ×DOL
EBIT
C
Earning before Interest and Tax
Contribution
DOL = =
EBIT I
EBIT
Earning after Interest
Earning before Interest and Tax
DFL
−
= =
EBIT I
CQ
EBIT
CQ
EBIT T
EBIT
−
× =
−
=
Degree of Combined leverage
Fianancial Management & International Finance
Leverage
EBIT I
C
Earning after Interest
Contribution
DCL
−
= =
OPERATING LEVERAGE AND CVP ANALYSIS AND EPS, INDIFFERENCE POINT :
Operating Break Even Point (BEP)
This is value of Q, at which EBIT = 0.
If operating break even point is denoted by Q1 units, then
SQ1 – VQ1 – Fixed Cost = 0
Q1 (S – V) – Fixed Cost = 0
Q1 (Contribution) – Fixed Cost = 0
. 1 OperatingBEP
Contribution
Fixed Cost
Q = ⇒
Whereas,
EBIT
Contribution
DOL =
l Thus EBIT is negative below operating BEP, thus DOL is negative below that point.
l EBIT is positive above operating BEP, DOL is positive above that point.
l EBIT = 0 at operating BEP. DOL is undefined at operating BEP.
l DFL = 0 at operating BEP, as at operating BEP, EBIT = 0.
Earning per Share
If interest = I
Tax per Rs. of taxable income = t
Preference Dividend = D
No of equity shares = E
N
EBIT I I t D
EPS
− − −
=
( ) ( )
EBIT – EPS Indifference Point
The amount of EBIT, at whcih EPS under two capital mixes are equal, is called the
EBIT – EPS indifference point.
To explain this, we may use the following equation :
N
EBIT I t D
EPS
− − −
=
( ) (1 )
Fianancial Management & International Finance
O
EPS
G
Mix 1
Mix 2
EBIT
ILLUSTRATIONS
Illustration 1
Calculate the degree of operating leverage (DOL), degree of financial leverage (DFL) and the
degree of combined leverage (DCL) for the following firms and interpret the results.
Firm K Firm L Firm M
1. Output (Units) 60,000 15,000 1,00,000
2. Fixed costs (Rs.) 7,000 14,000 1,500
3. Variable cost per unit (Rs.) 0.20 1.50 0.02
4. Interest on borrowed funds (Rs.) 4,000 8,000 —
5. Selling price per unit (Rs.) 0.60 5.00 0.10
Solution :
Firm K Firm L Firm M
Output (Units) 60,000 15,000 1,00,000
Selling Price per unit (Rs.) 0.60 5.00 0.10
Variable Cost per unit 0.20 1.50 0.02
Contribution per unit (Rs.) 0.40 3.50 0.08
Putting two different values of I, D and N in the above eqution, we can find two equation
representing EPS in terms of EBIT under two proposed mixes.
Equating these two equations, and solving for EBIT, we can find the indifference point.
The linear relationship developed between EBIT and EPS using above equation for two capital
mixes can be plotted on a graph paper in the form of two straight lines. In the following
figure, the indifference point is shown at point G.
442
Leverage
Total Contribution Rs. 24,000 Rs. 22,000 Rs. 8,000
(Unit × Contribution per unit)
Less : Fixed Costs 7,000 14,000 1,500
EBIT 17,000 38,500 6,500
Less : Interest 4,000 8,000 —
Profit before Tax (P.B.T.) 13,000 30,500 6,500
Degree of Operating Leverage
=
EBIT
Contribution
17 000
24 000
,
,
38 000
52 500
,
,
6 500
8 000
,
,
= 1.41 = 1.36 = 1.23
Degree of Financial Leverage
=
PBT
EBIT
13 000
17 000
,
,
30 500
38 500
,
,
6 500
500
,
6,
= 1.31 = 1.26 = 1.00
Degree of Combined Leverage
=
PBT
Contribution
13 000
24 000
,
,
13 500
52 500
,
,
6 500
8 000
,
,
= 1.85 = 1.72 = 1.23
Interpretation :
High opeating leverage combined with high financial leverage represents risky situation.
Low operating leverage combined with low financial leverage will constitute an ideal situation.
Therefore, firm M is less risky because it has low fixed cost and no interst an consequently
low combined leverage.
Illustration 2.
A firm has sales of Rs. 10,00,000, variable cost of Rs. 7,00,000 and fixed costs of Rs. 2,00,000
and debt of Rs. 5,00,000 at 10% rate of interst. What are the operating, financial and combined
leverages? It the firm wants to double its Earnings before interst and tax (EBIT), how much
of a rise in sales would be needed on a percentage basis?
Solution :
Statement of Existing Profit
Sales Rs. 10,00,000
Less : Variable Cost 7,00,000
Contribution 3,00,000
Less : Fixed Cost 2,00,000
EBIT 1,00,000
Less : Interest @ 10% on 5,00,000 50,000
Profit before tax (PBT) 50,000
443
Opeating Leverage = 1 00 000
3 00 000
, ,
, ,
EBIT
Contribution = = 3
Financial Leverage = 50 000
1 00 000
,
, ,
PBT
EBIT = = 2
Statement of Sales needed to Double the EBIT
Operating leverage is 3 times i.e., 33-1/3% incease in sales volume cause a 100% increase in
opeating profit or EBIT. Thus, at the sales of Rs. 13,33,333, operating profit or EBIT will
become Rs. 2,00,000 i.e., double the existing one.
Verification
Sales Rs. 13,33,333
Variable Cost (70%) 9,33,333
Contribution 4,00,000
Fixed Costs 2,00,000
EBIT 2,00,000
Illustration 3.
X Corporation has estimated that for a new product its break-even point is 2,000 units if the
items is sold for Rs. 14 per unit; the cost accounting department has currently identified
variable cost of Rs. 9 per unit. Calculate the degree of operating leverage for sales volume of
2,500 units and 3,000 units. What do you infer from the degree of operating leverage at the
sales volumes of 2,500 units and 3,000 units and their difference if any?
Solution :
Statement of Operating Leverage
Particulars 2500 Units 3000 Units
Sales @ Rs. 14 per unit 35,000 42,000
Variable cost 22,500 27,000
Contribution 12,500 10,000
Fixed cost (2000×Rs. 14–9) 10,000 10,000
EBIT 2,500 5,000
= =
EBIT
Contribution
Operating
2 500
12 500
,
,
5 000
15 000
,
,
= 5 5
At the sales volume of 3000 units, the operating profit is Rs. 5,000 which is double the opeating
profit of Rs. 2,500 (sales volume of 2,500 units) because of the fact that the operating leverage
is 5 times at the sales volume of 2,500 units. Hence increase of 20% in sales volume, the
operating profit has increased by 100% i.e., 5 times of 20%. At the level of 3000 units, the
operating leverage is 3 times. If there is change in sales from the level of 3,000 units, the %
increase in EBIT would be three times that of % increase in sales volume.
444
Leverage
Illustration 4.
The following information is available for ABC & Co.
EBIT Rs. 11,20,000
Profit before Tax 3,20,000
Fixed costs 7,00,000
Calculate % change EPS if the sales are expected to increase by 5%.
Solution :
In order to find out the % change in EPS as a result of % change in sales, the combined
leverage should be calculated as follows :
Operating Leverage = Contribution/EBIT
= Rs. 11,20,000+Rs. 7,00,000/11,20,000
= 1.625
Financial Leverage = EBIT/Profit before Tax
= Rs 11,20,000/3,20,000
= 3.5
Combined Leverage = Contribution/Profit before tax = OL×FL
= 1.625×3.5 = 5.69.
The combined leverage of 5.69 implies that for 1% change in sales level, the % change in EPS
would be 5.69%. So, if the sales are expected to increase by 5%, then the % increase in EPS
would be 5×5 = 28.45%.
Illustration 5.
XYZ and Co. has three financial plans before it, Plan I, Plan II and Plan III. Calculate operating
and financial leverage for the firm on the basis of the following information and also find out
the highest and lowest value of combined leverage :
Production 800 Units
Selling Price per unit Rs. 15
Variable cost per unit Rs. 10
Fixed Cost : Situation A Rs. 1,000
Situation B Rs. 2,000
Situation C Rs. 3,000
Capital Structure Plan I Plan II Plan III
Equity Capital Rs. 5,000 Rs. 7,500 Rs. 2,500
12% Debt 5,000 2,500 7,500
Solution :
Calculation of Operating Leverage :
Situation A Situation B Situation C
Number of unit sold 800 800 800
Sales @ Rs. 15 12,000 12,000 12,000
445
Variable cost @ Rs. 10 8,000 8,000 8,000
Contribution 4,000 4,000 4,000
Fixed cost 1,000 2,000 3,000
EBIT 3,000 2,000 1,000
Operating Leverage 1.33 2.00 4.00
(Contribution/EBIT)
Calculation of Financial Leverage :
Plan I Plan II Plan III
Situation A
EBIT Rs. 3,000 Rs. 3,000 Rs. 3,000
Less : Interest @ 12% 600 300 900
Profit before Tax 2,400 2,700 2,100
Financial Leverage 1.25 1.11 1.43
(EBIT/Profit befre Tax)
Situation B
EBIT Rs. 2,000 Rs. 2,000 Rs. 2,000
Less : Interest @ 12% 600 300 900
Profit before Tax 1,400 1,700 1,100
Financial Leverage 1.43 1.18 1.82
(EBIT/Profit befre Tax)
Situation C
EBIT Rs. 1,000 Rs. 1,000 Rs. 1,000
Less : Interest @ 12% 600 300 900
Profit before Tax 400 700 100
Financial Leverage 2.5 1.43 10.0
(EBIT/Profit befre Tax)
Calculation of Combined Leverage :
The conbined leverage may be calculated by multiplying the operating leverage and financial
leverage for different combination of Situation A, B & C and the Financial Plans, I, II & III as
follows :
Situation A Situation B Situation C
Plan I 1.66 2.86 10
Plan II 1.47 2.36 5.72
Plan III 1.90 3.64 40
The calculation of combined leverage shows the extent of the total risk and is helpful to
understand the variability of EPS as a consequence of change in sales levels. In this case, the
highest combined leverages is there when financial plan III is implemented in situation C;
446
Leverage
and lowest value of combined leverage is attained when financial Plan II is implemented in
situation A.
Illustration 6.
The folowing data relates to two companies A Ltd. and B Ltd.
A Ltd. B Ltd.
Capital Employed :
Equity share capital (in Rs. 10 shares) 5,00,000 2,50,000
9% Debentures — 2,50,000
Earnings before interest and tax 1,00,000 1,00,000
Return on capital employed 20% 20%
The equity shareholders of A Ltd. find to their dismay that in spite of same return earned by
their company on the total capital employed, their earning per share is much less as compared
to B Ltd.
You are required to state for the satisfaction of the shareholders of A Ltd., the reasons for
such lower earnings per share on their capital. Assume the tax at 50%.
Solution :
In order to find out the reasons for a higher rate of earning for the shareholders of B Ltd., the
earning per share for both the companies have to be calculated :
Computation of Earning per Share
A Ltd. B Ltd.
Eearnings before Interest and Tax Rs. 1,00,000 Rs. 1,00,000
Less : Debenture interest — 22,500
Profit before tax 1,00,000 77,500
Less : Taxes at 50% 50,000 38,750
Profit after tax 50,000 38,750
Numbers of shares 50,000 25,000
Earning per share (EPS) 1 1.55
Financial leverage =
PBT
EBIT
1 00 000
1 00 000
, ,
, ,
77 500
1 00 000
,
, ,
= 1 = 1.29
On the basis of above calculations, two causes which leads to lower EPS in case of A Ltd. as
compared to EPS of B Ltd. may be noted as follows :
(i) The B Ltd. has a higher financial leverage of 1.29 and it is taking the advantage of
cheaper debt. It has borrowed half of its capital funds @ 9% which is much lower
than the return on capital employed of 20%. This savings of 11% has resulted in the
benefit to the shareholders and thus has a higher EPS. The benefit of employing cheaper
debt may be explained as follows :
447
11% Saving on Rs. 2,50,000 Rs. 27,500
Less : Tax paid @ 50% 13,750
Net benefit to the shareholders Rs. 13,750
This extra benefit of Rs. 13,750 available to the equity shareholders has resulted in higher
EPS by Rs. .55 for the shareholders of B Ltd. (i.e., Rs. 13,750/25,000).
(ii) The total umber of equity shares in B Ltd. is 25000 as against the 50000 shares issued
by A Ltd. Consequently, the after tax benefit has accrued to the shareholder of 25000
shares only and has resulted in increase in the EPS of B Ltd. as compared to EPS of A
Ltd.
Illustration 7.
The selected financial data for A, B and C companies for the year ended March, 2009 are as
follows :
P Q R
Variable expenses as a % Sales 66.67 75 50
Interest Rs. 200 Rs. 300 Rs. 1,000
Degree of Operating leverage 5 : 1 6 : 1 2 : 1
Degree of Financial leverage 3 : 1 4 : 1 2 : 1
Income tax rate 50% 50% 50%
Prepare Income Statements for A, B and C companies.
Solution :
The information regarding the operating leverage and financial leverage may be intepretated
as follows–For Company P, the DFL is 3 : 1 (i.e., EBIT : PBT) and it means that out of EBIT of
3, the PBT is 1 and the remaining 2 is the interest component. Or, in other words, the EBIT :
Interest is 3 : 2. Similarly, for the operating leverage of 6 : 1 (i.e., Contribution- EBIT) for
Company Q, it means that out of Contribution of 6, the EBIT is 1 and the balance
5 is fixed costs. In other words, the Fixed costs : EBIT is 5 : 1. This information may be used to
draw the statement of sales and profit for all the three firms as follows :
Statement of Operating Profit and Sales
Particulars P Q R
Financial leverage = (EBIT/PBT) = 3 : 1 4 : 1 2 : 1
or, EBIT/Interest 3 : 2 4 : 3 2 : 1
Interest Rs. 200 Rs. 300 Rs. 1,000
EBIT 200×3/2 300×4/3 1,000×2/1
= 300 = 400 = 2,000
Operating leverage = (Cont./EBIT) = 5 : 1 6 : 1 2 : 1
i.e., Fixed Exp./EBIT = 4 : 1 5 : 1 1 : 1
Variable Exp. to Sales 66.67% 75% 50%
Contribution to Sales 33.33% 25% 50%
Fixed costs 300×4/1 400×5/1 2,000×1/1
448
Leverage
= 1,200 = 2,000 = 2,000
Contribution = (Fixed cost + EBIT) 1,500 2,400 4,000
Sales 4,500 9,600 8,000
Income Statement for the year ended 31.03.09
Particulars P Q R
Sales Rs. 4,500 Rs. 9,600 Rs. 8,000
Variable cost 3,000 7,200 4,000
Contribution 1,500 2,400 4,000
Fixed Costs 1,200 2,000 2,000
EBIT 300 400 2,000
Interest 200 300 1,000
PBT 100 100 1,000
Tax at 50% 50 50 500
Profit after Tax (PAT) 50 50 500
Operating leverage (Cont./EBIT) = 5 6 2
Financial leverage (EBIT/PBT) = 3 4 2
Combined leverage 15 24 4
Illustration 8.
The following data is available for XYZ Ltd. :
Sales Rs. 2,00,000
Less : Variable cost @30% 60,000
Contribution 1,40,000
Less : Fixed Cost 1,00,000
EBIT 40,000
Less : Interest 5,000
Profit before tax 35,000
Find out :
(i) Using the concept of financial leverage, by what percentage will the taxable income
increase if EBIT increase by 6%.
(ii) Using the concept of operating leverage, by what percentage will EBIT increase if
there is 10% increase in sales, and
(iii) Using the concept of leverage, by what percentage will the taxable income increase if
the sales increase by 6%. Also verify results in view of the above figures.
Solution :
(i) Degree of financial leverage :
DFL = EBIT/Profit before Tax = 40,000/35,000
= 1.15
If EBIT increase by 6%, the taxable income will increase by 1.15×6 = 6.9% and it may be
verified as follows :
EBIT (after 6% increase) Rs. 42,400
Less : Interest 5,000
Profit before Tax 37,400
Increase in taxable income in Rs. 2,400 i.e., 6.9% of Rs. 35,000
(ii) Degree of operating leverage :
DOL = Contribution/EBIT = 1,40,000/40,000 = 3.50
If Sales increase by 10%, the EBIT will increase by 3.50×10 = 35% and it may be verified as
follows :
Sales (after 10% increase) Rs. 2,20,000
Less : Variable Expenses @30% 66,000
Contribution 1,54,000
Less : Fixed cost 1,00,000
EBIT 54,000
Increase in EBIT is Rs. 14,000 i.e., 35% of Rs. 40,000.
(iii) Degree of combined leverage :
DCL = Contribution/Profit before Tax = 1,40,000/35,000
= 4
If Sales increases by 6%, the profit before tax will increase by 4×6 = 24% and it may be
verified as follows :
Sales (after 6% increase) Rs. 2,12,000
Less : Variable Expenses @ 30% 63,600
Contribution 1,48,400
Less : Fixed cost 1,00,000
EBIT 48,400
Less : Interest 5,000
Profit before Tax 43,400
Increase in Profit before tax is Rs. 8,400 i.e., 24% of Rs. 35,000.
Illustration 9.
(i) Find out operating leverage from the following data :
Sales Rs. 50,000
Variable Costs 60%
Fixed Costs Rs. 12,000
(ii) Find out of financial leverage from the following data :
Net Worth Rs. 25,00,000
Debt/Equity 3 : 1
Leverage
Interest rate 12%
Operating Profit Rs. 20,00,000
Solution :
(i) Sales Rs.50,000
Less : Variable cost at 60% 30,000
Contribution 20,000
Less : Fixed Cost 12,000
Operating Rs. 8,000
Operating Leverage
8 000
20 000
,
,
Operating Profit
= Contribution = = 2.50
(ii) Net worth = Rs. 25,00,000
Debt/Equity = 3 : 1
Hence Debt = Rs. 75,00,000
EBIT 20,00,000
Less : Interest at 12% on 75,00,000 9,00,000
PBT 11,00,000
Financial Leverage 1 82
11 00 000
20 00 000
.
, ,
, ,
PBT
= EBIT = =
Illustration 10.
From the following, prepare Income Statements of A, B and C. Briefly comment on each
firm’s performance :
Firm A Firm B Firm C
Financial Leverage 3 : 1 4 : 1 2 : 1
Interest Rs. 200 Rs. 300 Rs. 1,000
Operating Leverage 4 : 1 5 : 1 3 : 1
Variable cost as a % of sales 66.67% 75% 50%
Income-tax Rate 45% 45% 45%
Solution :
Firm A Financial Leverage =
1
3 =
EBT
EBIT
or EBIT = 3 × EBT .... (1)
Again EBIT–Interest = EBT
or EBIT-200 = EBT .... (2)
Taking (1) and (2) we get 3 EBT–200 = EBT
or 2 EBT=200 or EBT = Rs. 100
Hence EBIT=3EBT = Rs.300
Again, the operating leverage = Contribution/EBIT = 4/1
EBIT = Rs. 300,
Contribution = 4×EBIT = Rs. 1,200
Now variable cost = 66.67% on sales
Contribution = 100–66.67% i.e., 33-1/3% on sales
Hence sales = 1200/33-1/3% = Rs. 3,600.
Same way EBIT, EBT, Contribution and Sales for firms B and C can be worked out.
Firm B =
1
4 =
EBT
EBIT
or EBIT = 4EBT ... (3)
Again EBIT–Interest = EBT or EBIT–300=EBIT ... (4)
Taking (3) and (4) we get 4EBT–300 = EBT
or 3EBT=300 or EBT = Rs. 100
Hence EBIT = 4×EBT = Rs. 400
Again Operating leverage = Contribution/EBIT = 5/1
EBIT = Rs. 400, Hence Contribution = 5×EBIT = 2,000
Now variable cost = 75% on Sales
Contribution = 100–75% i.e., 25% on Sales
Hence Sales = 2000/25% = Rs. 8,000.
Firm C Financial Leverage =
1
2 =
EBT
EBIT
or EBIT = 2EBT ... (5)
EBT 1
Again EBIT–Interest = EBT or EBIT – 1000 = EBT ... (6)
Taking (5) and (6) we get 2EBT–1000 = EBT or EBT = 1,000
Hence EBIT = 2 × EBT = Rs. 2,000
Again Operating leverage = Contribution/EBIT =3/1
EBIT = Rs. 2,000, Hence Contribution = 3×EBIT=6,000
Now Variable cost = 50% on Sales
Contribution = 100 – 50 = 50% on Sales
Hence Sales = 6,000/50% = Rs. 12,000.
Income Statement
Firm A Firm B Firm C
Sales Rs. 3,600 Rs. 8,000 Rs. 12,000
Less : Variable Cost 2,400 6,000 6,000
Contribution 1,200 2,000 6,000
Less : Fixed cost 900 1,600 4,000
EBIT 300 400 2,000
Less : Interest 200 300 1,000
452
Leverage
EBT 100 100 1,000
Less : Tax @ 45% 45 45 450
Profit after Tax (PAT) 55 55 550
Interpretation
The financial position of firm C can be regarded better than that of other firm A and B
because of the following reasons :
(i) Financial leverage is the measure of financial risk. Firm C has the least financial risk as
it has minimum degree of financial leverge. No doubt it is true that there will be a
more magnified impact on earnings per share on A and B firms that that of C due to
change in EBIT but their EBIT level due to low sales is very low suggesting that such
an advantage is not great.
(ii) Degree of combined leverage is maximum in firm B i.e., 20, against firm A i.e., 12 and
firm C i.e., 6. Clearly, the total risk (business and financial) complexion of firm C is the
lowest, while that of other firms are very high.
(iii) The ability of firm C to meet interest liability is better than that of firms A and B as
follows :
EBIT/Interest ratio for three firms :
A = 300/200 = 15
B = 400/300 = 1.33
C = 2,000/1,000 = 2
Comment (1)
April 10, 2019 at 2:28 PM
ts really great post I have some important information on your blog its very helpful for me.
Highest Leverage
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