Types of Leverages (Operating, Financial, and Combined), EBIT-EPS Analysis, and Other Factors | Commerce & Accountancy Optional Notes for UPSC PDF Download

Introduction

• In the realm of financial decision-making, the capital structure decision holds significant importance. It pertains to the composition of debt and equity within an organization, with a primary focus on the resultant risk and return for shareholders, which is crucial for finance managers. When the amount of borrowed funds exceeds that of the owners’ funds, shareholders' earnings may increase, but it also elevates the organization's risk level. Conversely, if the proportion of equity funds surpasses that of borrowed funds, shareholders' return and risk tend to be lower. 
• This underscores the importance of establishing an optimal capital structure that aligns risk and return for shareholders. Understanding the impact of capital structure on shareholder risk and return can aid finance managers in formulating both short-term and long-term strategies. Analyzing the behavior and utilization of leverage provides valuable insight into this issue from the appropriate standpoint.

Concept and Types of Leverage

• The term "leverage" denotes an increased capability to achieve a specific goal, often involving the amplification of force to lift heavy objects through the application of a lever.
• James Horne defines leverage as the utilization of an asset or funds for which the firm incurs a fixed cost or receives a fixed return. Christy and Roder characterize leverage as the propensity for profits to fluctuate at a faster pace than sales.
• Key characteristics of leverage include: (a) its application to the utilization of assets or funds, (b) the tendency for profits to change more rapidly than sales, (c) the presence of a risk-return relationship typically moving in the same direction, and (d) a correlation where higher leverage corresponds to increased risk and anticipated returns.

An overview of various types of leverage is outlined below:

Return on Investment Leverage serves as an indicator of operational efficiency and is calculated as follows:

• EBIT/Total Assets

Asset Leverage is the part of ROI leverage. It is like assets turnover. It is calculated as follows :

• Sales/Total Assets 

A firm with a relatively high turnover is said to have a high degree of asset leverage.

Operating Leverage is related to fixed cost. It indicates the impact of changes in sales on operating income. It is calculated as follows:

• Contribution/EBIT 

Financial Leverage depends upon the ratio of debt and preferred stock together to common shares. It is calculated  with the help of EBIT and EBT as below : 

• EBIT/EBT

Combined Leverage is the multiplication of operating leverage and financial leverage.

Operating Leverage

It takes place when a change in revenue produces a greater change in EBIT. It is related to fixed costs. A firm with relatively high fixed costs uses much of its marginal contribution to cover fixed costs.

Definition: Operating leverage pertains to the extensive utilization of fixed assets. Several explanations include:

• "The utilization of fixed operating expenses to amplify changes in profits in relation to a given change in Sales" - Walker & Petty
• "If a significant portion of a firm's total expenses consists of fixed costs, then the firm is considered to have a high degree of operating leverage." - E. F. Brigham

Operating leverage is determined by three factors:

• Fixed costs
• Contribution
• Volume of Sales

Distinctive attributes of operating leverage encompass:

• It influences the asset side of the balance sheet
• It correlates with the composition of fixed assets
• It is intertwined with fluctuations in business risk
• It impacts the capital structure and return on total assets.

Computation of OL

The operating leverage can be calculated by the following formula

where contribution means sales minus variables costs EBIT means contribution minus fixed costs. If contribution is more than fixed cost, it is favourable financial leverage. In case of vice-versa, it is unfavourable financial leverage.

Illustration No: The following are the details
Selling price per unit Rs. 20
Variable cost per unit Rs. 12
Actual sales 200 units
Installed capacity 300 units
Calculated operating leverage in each of the following two situations.

• when fixed costs are Rs. 1000
• when fixed costs are Rs. 800.

Solution: Statement showing computation of operating leverage

Behaviour of Operating Leverage

The behaviour of operating leverage may be measured by the degree of operating leverage. The degree of operating leverage is the percentage change in the profits resulting from a percentage change in the sales. It may be put in the form of the following formula: 

If a firm has a high degree of operating leverage, small change in sales will have large effect on operating income. Similarly, the operating profits of such a firm will suffer loss as compared to decrease in its sales. There will not be any operating leverage, if there are no fixed costs. 

Applications

The operating leverage indicates the impact of change in sales on operating income. If a firm has a high degree of operating leverage, small change in sales will have large effect on operating income. A few areas of application are as follows : 

• Operating leverage has an important role in capital budgeting decisions. Infact, this concept was originally developed for use in capital budgeting.
• Long term profit planning is also possible by looking at quantam of fixed cost investment and its possible effects.
• Generally, a high degree of operating leverage increases the risk of a firm. For deciding capital structure in favour of debt, the impact of further increase in risk will influence capital structure decision.

Financial Leverage

Financial leverage involves the utilization of debt in the company's capital structure. It encompasses the utilization of fixed-cost capital (debt) in the overall capitalization of the firm, which includes loans, debentures, and preference share capital.

Meaning:

• Financial leverage denotes the firm's capacity to utilize fixed financial costs in a manner that amplifies the impact on EPS (Earnings Per Share) resulting from any change in EBIT (Earnings Before Interest and Taxes). Essentially, financial leverage involves employing debt capital to enhance the return on equity.
• As per Guthman, "Financial leverage refers to the firm's ability to utilize fixed financial changes to magnify the effect of changes in EBIT on the firm's EPS."

Key aspects of financial leverage include:

• It pertains to the liabilities side of the balance sheet.
• It is linked to the capital structure of the company.
• It is associated with financial risk.
• It impacts earnings after tax and earnings per share.
• Financial leverage can be either favorable or unfavorable. Unfavorable leverage occurs when the firm fails to earn enough to cover the cost of funds.

Computation of Financial Leverage

The financial leverage can be calculated by the following formula:
 where EBIT refers to earnings before interest and tax and EBT refers to earnings before tax but after interest 

Some authorities have used the term financial leverage in the context of establishing relationship between EBIT and EPS. The financial leverage shows the percentage change in EPS in relation to percentage change in EBIT.

Behaviour

The behaviour of financial leverage may be measured by the degree of financial leverage. The degree of financial leverage may be in the form of the following equation: 

Alternatively, this may be calculated in terms of EPS.

Application

Financial leverage is useful in (i) Capital structure planning (ii) Profit Planning

• Financial leverage helps the finance managers while devising the capital structure of the company. A high financial leverage means high fixed financial costs and high financial risk. Increase in fixed financial costs may force the company into liquidation. 

Composite Leverage 

Both operating and financial leverage magnify the returns. There is combined effect of these leverages on income. Both the leverages are closely concerned with the firm's capacity to meet its fixed costs (both operating and financial). In case both the leverages are combined, the result obtained will disclose the effect of change in sales over change taxable profit.
Composite Leverage =  Operating Leverage  * Financial Leverage

The degree of combined leverage is computed in the following manner:

Illustration: The following particulars are available:
Sales Rs. 1,00,000
Variable Cost Rs.    70,000
Fixed Cost Rs.    20,000
Long-term loans Rs.    50,000
At 10 percent
Compute the combined leverage
Solution:

EBIT - EPS ANALYSIS

This is a method to study the effect of leverage. It involves the comparisons of alternative methods of financing under various alternative financing proposals. A firm may raise funds in either of the following alternatives :

• Exclusive use of equity capital
• Exclusive use of debt
• Various combinations of debt and equity
• Various combinations of debt, equity and preferences capital

Importance of Leverage

Leverages play a crucial role in amplifying various financial metrics. Operating leverage increases the impact of EBIT in relation to contribution, while financial leverage enhances EPS concerning EBIT. Financial leverage boosts EPS without necessitating additional investments. By strategically managing asset and financing mixes, EPS can be augmented. Several key areas identified in this context include:

• Investment in fixed assets (Operating leverage)
• Capital structure planning (Financial leverage)
• Profit planning (Combined leverage)
• Monitoring business and financial risk
• Maximizing shareholder value
• Improving EPS
• Balancing operating leverage and financial leverage judiciously

It's important to note that a firm with high operating leverage should exercise caution with financial leverage, and vice versa. An optimal balance between the two leverages is essential to mitigate excessive risk exposure.