Financing Decisions - Leverages | Financial Management & Economics Finance: CA Intermediate (Old Scheme) PDF Download

 Page 1


 
LEARNING OUTCOMES 
 
 
 FINANCING DECISIONS
 - LEVERAGES 
 
 
? Understand the concept of business risk and financial risk 
? Discuss and Interpret the types of leverages. 
? Discuss the relationship between operating leverage, Break -
even analysis & Margin of Safety 
? Discuss positive and negative Leverage 
? Discuss Financial leverage as ‘Trading on equity’ 
? Discuss Financial Leverage as ‘Double Edged Sword’ 
Analysis of Leverage
Business and Financial Risk
Types of Leverage
(i)  Operating Leverage
(ii)  Financial Leverages
(iii) Combined Leverages
 
CHAPTER 
6 
Page 2


 
LEARNING OUTCOMES 
 
 
 FINANCING DECISIONS
 - LEVERAGES 
 
 
? Understand the concept of business risk and financial risk 
? Discuss and Interpret the types of leverages. 
? Discuss the relationship between operating leverage, Break -
even analysis & Margin of Safety 
? Discuss positive and negative Leverage 
? Discuss Financial leverage as ‘Trading on equity’ 
? Discuss Financial Leverage as ‘Double Edged Sword’ 
Analysis of Leverage
Business and Financial Risk
Types of Leverage
(i)  Operating Leverage
(ii)  Financial Leverages
(iii) Combined Leverages
 
CHAPTER 
6 
 
 
6.2 FINANCIAL MANAGEMENT  
6.1  INTRODUCTION 
Objective of financial management is to maximize wealth. Here wealth means 
market value. Value is directly related to performance of company and inversely 
related to expectation of investors. In turn expectation of investor is dependent on 
risk of the company. Therefore, to maximize value company should try to manage 
its risk. This risk may be business risk, financial risk or both. In this chapter we will 
discuss factors that influence business and financial risks.  
6.2 MEANING AND TYPES OF LEVERAGE 
6.2.1 Meaning of Leverage 
The term leverage represents influence or power. In financial analysis leverage 
represents the influence of one financial variable over some other related financial 
variable. These financial variables may be costs, output, sales revenue, Earnings 
Before Interest and Tax (EBIT), Earning per share (EPS) etc. Generally, if we want to 
calculate impact of change in variable X on variable Y, it is termed as Leverage of Y 
with X, and it is calculated as follows:  
Measurement of Leverage=
Change in Y÷Y
Change in X ÷X
 
6.2.2 Types of Leverage 
There are three commonly used measures of leverage in financial analysis. These 
are: 
(i) Operating Leverage: It is the relationship between Sales and EBIT and indicated 
business risk. 
(ii) Financial Leverage: it is the relationship between EBIT and EPS and indicates 
financial risk. 
Operating Leverage Business risk
Page 3


 
LEARNING OUTCOMES 
 
 
 FINANCING DECISIONS
 - LEVERAGES 
 
 
? Understand the concept of business risk and financial risk 
? Discuss and Interpret the types of leverages. 
? Discuss the relationship between operating leverage, Break -
even analysis & Margin of Safety 
? Discuss positive and negative Leverage 
? Discuss Financial leverage as ‘Trading on equity’ 
? Discuss Financial Leverage as ‘Double Edged Sword’ 
Analysis of Leverage
Business and Financial Risk
Types of Leverage
(i)  Operating Leverage
(ii)  Financial Leverages
(iii) Combined Leverages
 
CHAPTER 
6 
 
 
6.2 FINANCIAL MANAGEMENT  
6.1  INTRODUCTION 
Objective of financial management is to maximize wealth. Here wealth means 
market value. Value is directly related to performance of company and inversely 
related to expectation of investors. In turn expectation of investor is dependent on 
risk of the company. Therefore, to maximize value company should try to manage 
its risk. This risk may be business risk, financial risk or both. In this chapter we will 
discuss factors that influence business and financial risks.  
6.2 MEANING AND TYPES OF LEVERAGE 
6.2.1 Meaning of Leverage 
The term leverage represents influence or power. In financial analysis leverage 
represents the influence of one financial variable over some other related financial 
variable. These financial variables may be costs, output, sales revenue, Earnings 
Before Interest and Tax (EBIT), Earning per share (EPS) etc. Generally, if we want to 
calculate impact of change in variable X on variable Y, it is termed as Leverage of Y 
with X, and it is calculated as follows:  
Measurement of Leverage=
Change in Y÷Y
Change in X ÷X
 
6.2.2 Types of Leverage 
There are three commonly used measures of leverage in financial analysis. These 
are: 
(i) Operating Leverage: It is the relationship between Sales and EBIT and indicated 
business risk. 
(ii) Financial Leverage: it is the relationship between EBIT and EPS and indicates 
financial risk. 
Operating Leverage Business risk
 6.3 
FINANCING DECISIONS - LEVERAGES 
(iii) Combined Leverage: It is the relationship between Sales and EPS and indicated 
total risk. 
6.2.3 Chart Showing Degree of Operating Leverage, Financial Leverage 
and Combined leverage 
Profitability Statement   
Sales xxx   
Less: Variable Cost (xxx)   
Contribution xxx  Degree of Operating  
Leverage 
 
Less: Fixed Cost (xxx) 
Operating Profit/ EBIT xxx 
 
 
Less: Interest (xxx) 
Earnings Before Tax (EBT) xxx  Degree of  
Less: Tax (xxx)  Combined 
Profit After Tax (PAT) xxx  Leverage 
Less: Pref. Dividend (if any) (xxx) Degree of Financial  
Net Earnings available to equity 
shareholders/ PAT 
xxx Leverage  
No. Equity shares (N)    
Earnings per Share (EPS) = (PAT ÷ 
N) 
   
Financial Leverage Financial risk
Combined Leverage Total risk
Page 4


 
LEARNING OUTCOMES 
 
 
 FINANCING DECISIONS
 - LEVERAGES 
 
 
? Understand the concept of business risk and financial risk 
? Discuss and Interpret the types of leverages. 
? Discuss the relationship between operating leverage, Break -
even analysis & Margin of Safety 
? Discuss positive and negative Leverage 
? Discuss Financial leverage as ‘Trading on equity’ 
? Discuss Financial Leverage as ‘Double Edged Sword’ 
Analysis of Leverage
Business and Financial Risk
Types of Leverage
(i)  Operating Leverage
(ii)  Financial Leverages
(iii) Combined Leverages
 
CHAPTER 
6 
 
 
6.2 FINANCIAL MANAGEMENT  
6.1  INTRODUCTION 
Objective of financial management is to maximize wealth. Here wealth means 
market value. Value is directly related to performance of company and inversely 
related to expectation of investors. In turn expectation of investor is dependent on 
risk of the company. Therefore, to maximize value company should try to manage 
its risk. This risk may be business risk, financial risk or both. In this chapter we will 
discuss factors that influence business and financial risks.  
6.2 MEANING AND TYPES OF LEVERAGE 
6.2.1 Meaning of Leverage 
The term leverage represents influence or power. In financial analysis leverage 
represents the influence of one financial variable over some other related financial 
variable. These financial variables may be costs, output, sales revenue, Earnings 
Before Interest and Tax (EBIT), Earning per share (EPS) etc. Generally, if we want to 
calculate impact of change in variable X on variable Y, it is termed as Leverage of Y 
with X, and it is calculated as follows:  
Measurement of Leverage=
Change in Y÷Y
Change in X ÷X
 
6.2.2 Types of Leverage 
There are three commonly used measures of leverage in financial analysis. These 
are: 
(i) Operating Leverage: It is the relationship between Sales and EBIT and indicated 
business risk. 
(ii) Financial Leverage: it is the relationship between EBIT and EPS and indicates 
financial risk. 
Operating Leverage Business risk
 6.3 
FINANCING DECISIONS - LEVERAGES 
(iii) Combined Leverage: It is the relationship between Sales and EPS and indicated 
total risk. 
6.2.3 Chart Showing Degree of Operating Leverage, Financial Leverage 
and Combined leverage 
Profitability Statement   
Sales xxx   
Less: Variable Cost (xxx)   
Contribution xxx  Degree of Operating  
Leverage 
 
Less: Fixed Cost (xxx) 
Operating Profit/ EBIT xxx 
 
 
Less: Interest (xxx) 
Earnings Before Tax (EBT) xxx  Degree of  
Less: Tax (xxx)  Combined 
Profit After Tax (PAT) xxx  Leverage 
Less: Pref. Dividend (if any) (xxx) Degree of Financial  
Net Earnings available to equity 
shareholders/ PAT 
xxx Leverage  
No. Equity shares (N)    
Earnings per Share (EPS) = (PAT ÷ 
N) 
   
Financial Leverage Financial risk
Combined Leverage Total risk
 
 
6.4 FINANCIAL MANAGEMENT  
 6.3 OPERATING LEVERAGE 
Operating Leverage means tendency of operating income (EBIT) to change 
disproportionately with change in sale volume. This disproportionate change is 
caused by operating fixed cost, which does not change with change in sales volume.  
In other words, operating leverage (OL) maybe defined as the employment of an 
asset with a fixed cost so that enough revenue can be generated to cover all the 
fixed and variable costs. 
The use of assets for which a company pays a fixed cost is called operating leverage. 
Operating leverage is a function of three factors: 
(i) Amount of fixed cost, 
(ii) Variable contribution margin, and  
(iii) Volume of sales. 
6.3.1 Degree of Operating Leverage (DOL) 
When we measure magnitude of disproportionate change it is termed as degree of 
leverage. Degree of Operating Leverage may be defined as percentage change in EBIT 
with respect to percentage change in sales quantity.  
Degree of Operating Leverage=
Percentage Change in EBIT
Percentage Change in Sales
 
Mathematically: 
DOL= 
?EBIT
EBIT
  ?Q
Q
? 
Here, EBIT = Q (S-V) – F   
Q = sales quantity 
S = selling price per unit 
V = variable cost per unit 
? Denotes change 
 
Page 5


 
LEARNING OUTCOMES 
 
 
 FINANCING DECISIONS
 - LEVERAGES 
 
 
? Understand the concept of business risk and financial risk 
? Discuss and Interpret the types of leverages. 
? Discuss the relationship between operating leverage, Break -
even analysis & Margin of Safety 
? Discuss positive and negative Leverage 
? Discuss Financial leverage as ‘Trading on equity’ 
? Discuss Financial Leverage as ‘Double Edged Sword’ 
Analysis of Leverage
Business and Financial Risk
Types of Leverage
(i)  Operating Leverage
(ii)  Financial Leverages
(iii) Combined Leverages
 
CHAPTER 
6 
 
 
6.2 FINANCIAL MANAGEMENT  
6.1  INTRODUCTION 
Objective of financial management is to maximize wealth. Here wealth means 
market value. Value is directly related to performance of company and inversely 
related to expectation of investors. In turn expectation of investor is dependent on 
risk of the company. Therefore, to maximize value company should try to manage 
its risk. This risk may be business risk, financial risk or both. In this chapter we will 
discuss factors that influence business and financial risks.  
6.2 MEANING AND TYPES OF LEVERAGE 
6.2.1 Meaning of Leverage 
The term leverage represents influence or power. In financial analysis leverage 
represents the influence of one financial variable over some other related financial 
variable. These financial variables may be costs, output, sales revenue, Earnings 
Before Interest and Tax (EBIT), Earning per share (EPS) etc. Generally, if we want to 
calculate impact of change in variable X on variable Y, it is termed as Leverage of Y 
with X, and it is calculated as follows:  
Measurement of Leverage=
Change in Y÷Y
Change in X ÷X
 
6.2.2 Types of Leverage 
There are three commonly used measures of leverage in financial analysis. These 
are: 
(i) Operating Leverage: It is the relationship between Sales and EBIT and indicated 
business risk. 
(ii) Financial Leverage: it is the relationship between EBIT and EPS and indicates 
financial risk. 
Operating Leverage Business risk
 6.3 
FINANCING DECISIONS - LEVERAGES 
(iii) Combined Leverage: It is the relationship between Sales and EPS and indicated 
total risk. 
6.2.3 Chart Showing Degree of Operating Leverage, Financial Leverage 
and Combined leverage 
Profitability Statement   
Sales xxx   
Less: Variable Cost (xxx)   
Contribution xxx  Degree of Operating  
Leverage 
 
Less: Fixed Cost (xxx) 
Operating Profit/ EBIT xxx 
 
 
Less: Interest (xxx) 
Earnings Before Tax (EBT) xxx  Degree of  
Less: Tax (xxx)  Combined 
Profit After Tax (PAT) xxx  Leverage 
Less: Pref. Dividend (if any) (xxx) Degree of Financial  
Net Earnings available to equity 
shareholders/ PAT 
xxx Leverage  
No. Equity shares (N)    
Earnings per Share (EPS) = (PAT ÷ 
N) 
   
Financial Leverage Financial risk
Combined Leverage Total risk
 
 
6.4 FINANCIAL MANAGEMENT  
 6.3 OPERATING LEVERAGE 
Operating Leverage means tendency of operating income (EBIT) to change 
disproportionately with change in sale volume. This disproportionate change is 
caused by operating fixed cost, which does not change with change in sales volume.  
In other words, operating leverage (OL) maybe defined as the employment of an 
asset with a fixed cost so that enough revenue can be generated to cover all the 
fixed and variable costs. 
The use of assets for which a company pays a fixed cost is called operating leverage. 
Operating leverage is a function of three factors: 
(i) Amount of fixed cost, 
(ii) Variable contribution margin, and  
(iii) Volume of sales. 
6.3.1 Degree of Operating Leverage (DOL) 
When we measure magnitude of disproportionate change it is termed as degree of 
leverage. Degree of Operating Leverage may be defined as percentage change in EBIT 
with respect to percentage change in sales quantity.  
Degree of Operating Leverage=
Percentage Change in EBIT
Percentage Change in Sales
 
Mathematically: 
DOL= 
?EBIT
EBIT
  ?Q
Q
? 
Here, EBIT = Q (S-V) – F   
Q = sales quantity 
S = selling price per unit 
V = variable cost per unit 
? Denotes change 
 
 
 
 6.5 
 
FINANCING DECISIONS - LEVERAGES 
 
DOL= 
? [Q (S-V)-F] / [Q (S-V)-F] 
?Q / Q  
 
Now ?F is nil because change in fixed cost is nil. Therefore: 
 
DOL= 
? Q (S-V)
Q (S-V)-F
  
? Q
Q
?   =    
? Q (S-V)
Q (S-V)-F
×
Q
? Q
    = 
 Q (S-V)
Q (S-V)-F
 
 
 
DOL= 
Contribution
Contribution-Fixed Cost
= 
Contribution
EBIT
 
 
6.3.2 Break-Even Analysis and Operating Leverage  
Break-even analysis is a generally used to study the Cost Volume Profit analysis. It 
is concerned with computing the break-even point. At this point of production level 
and sales there will be no profit and loss i.e. total cost is equal to total sales revenue. 
Break-even point in units = 
Fixed  Cost
Contribution per unit
 
Let us Understand through the following example: 
Example - 1: 
Particulars Product X Product Y 
 (`) (`) 
Selling Price 40 20 
Variable Cost 20 12 
Contribution 20 8 
Total Contribution of 1,000 units 20,000 8,000 
Fixed Cost 15,000 5,000 
Profit (EBIT) 5,000 3,000 
Break- even point (Fixed Cost / 
Contribution  
15,000
 = 750
20
units 
5,000
 = 625
8
units 
Operating Leverage  
Contribution
EBIT
? ?
? ?
? ?
 
20,000
 = 4
5,000
 
8,000
 = 2.67
3,000