Appendix C - Leverage

8/9/2019 Appendix C - Leverage

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J B GUPTA CLASSES98184931932, [email protected],

www.jbguptaclasses.com

Copyright: Dr JB Gupta

APPENDIX CAPPENDIX CAPPENDIX CAPPENDIX C

LEVERAGELEVERAGELEVERAGELEVERAGE

Leverage1 is an assisted advantage. To leverage means to gain an advantage

through the use of a tool. In the word of finance, the term is applied to (i) fixed

cost and (ii) cost of fixed commitment funds (interest, preference dividend) as

being used to maximize the EPS. There are three types of leverage (i) OperatingLeverage (ii) Financial leverage and (iii) Combined leverage.

Operating leverage is tendency of EBIT to vary disproportionately with sales.

This happens because every enterprise has fixed costs which have to be met

regardless of volume of sales. Fixed costs remain fixed whether sales increase

or decrease. Therefore the percentage changes in operating profit on account of

a change in sales is greater than the percentage change in sales.

Financial leverage can be defined as the tendency of the EBT to vary

disproportionately with net operating income (EBIT). In other words, change in

EBIT results in a larger change in EBT (and accordingly in EAT, also in EPS).

This happens because of fixed commitments on debentures, loans, etc. Hence, ifthere is a change in EBIT, it will result a larger change in the return of owners

funds. Financial leverage will be higher in case of firms with higher debt equity

ratio.

Operating leverage indicates towards business risk (i.e. possibility suffering loss

in case of fall in sates) and financial leverage indicates towards financial risk

(i.e., possibility of bankruptcy in case of fall in EBIT). The total risk involved can

be seen by combining the operating leverage and financial leverage. This

combination is known as composite leverage.

1A lever is a device that (i) multiplies the force and (ii) a makes it available at a

particular point. A pair of scissors is a common example of lever, what we cannot

cut (without using the pair of scissors) by applying all our force, we can cut

(applying the same force, or sometimes lesser force) the same using the pair of

scissors. (the pair of scissor multiplied our force and provided at the point

where the cut was required )


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Example:

Rs. Rs

Sales 1,00,000 1,10,000

VC 50,000 55,000

Contribution 50,000 55,000

F.C. 20,000 20,000

EBIT (operating profit) 30,000 35,000

Interest 5,000 5,000E.B.T. 25,000 30,000

Tax 12,500 15,000

E.A.T. 12,500 15,000

E.P.S. (assumed 10,000 shares) 1.25 1.50

In the above example, we find that when sales increased by 10%,

EBIT (operating profit) increase by (5000 / 30000) x 100 = 16.66 %. This

tendency, i.e. operating profit changes at a higher rate than that of rate of

change of sales, it known as operating leverage. When operating profit changed

by 16.66 percent, EBT changed by 20 percent, EAT changed by 20 percent, EPS

also changed by 20 percent. This tendency, i.e. EBT, EAT or EPS changes at a

higher rate, than that rate of change of EBIT, is known as financial leverage. The

tendency of disproportionate change of EBT/EAT/EPS on change in sales is

known as composite leverage.

% change in EBIT

Operating leverage =

% change in Sales

16.67

= = 1.66710

% change in EBT or EAT or EPS

Financial Leverage =

% change in EBIT

20

= = 1.20

16.67


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% change in EBT or EAT or EPS

Combined Leverage =

% change in sales

20

= = 2

10

ShortShortShortShort----cut ways of calculationcut ways of calculationcut ways of calculationcut ways of calculation

Operating leverage = Contribution/EBIT

50,000

= = 1.66630,000

Financial leverage = EBIT/EBT

30,000

= 1.20

25,000

Composite leverage = Contribution/EBT

50,000

= 225,000

This note is based on the assumption that there is no preference dividend. If

preference dividend is there, replace, in the above note, (i) the term EBT by

EBT pre tax profit required to pay the preference dividend & (ii) the term

EAT by EAT preference dividend including dividend distribution tax(es) if any.

Interpretation of Leverages

If degree of operating leverage is 2, it means for every 1 per cent increase insales, EBIT will be up by 2 per cent.

If degree of financial leverage is 2, it means for every 1 per cent increase

in EBIT, EBT/EAT/EPS will go up by 2 per cent.

If degree of composite leverage is 4, it means for every 1 per cent

increase in sales, EBT/EAT/EPS will go up by 4 per cent.

Q. No.Q. No.Q. No.Q. No. 1111 : The net sales of A Ltd. is 30 Crores, EBIT is 12% of sales. The Capital

employed. ESC Rs.10 Crores, 13% PSC Rs.2 Crores and 15% Debentures Rs.6


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Crores. Tax 40%. Ignore CDT, education cess and surcharge. Calculate return on

equity and indicate its segments due to presence of PSC and debentures. Given

that the combined leverage is 4, calculate the operating leverage

AnswerAnswerAnswerAnswer:

EBIT = 12% of 30 Crores Rs.3.60 Crores

Interest Rs.0.90 Crores

Tax Rs.1.08 Crores

EAT Rs.1.62 Crores

Pref. Dividend Rs.0.26 Crores

Earnings for equity shareholders Rs.1.36 Crores

ESC Rs.10.00 Crores

Return on equity (1.36/ 10.00) x 100 = 13.60 %

Return on capital employed =

[EBIT] / [(ESC + PSC + DEBT)] = [3.60] / [10 + 2 + 6 ] = 20%

Calculation of profit for equity shareholders: (Rs. Crores)

Source of

funds

Earnings

on funds

Interest Tax Pref.

Div.

Profit for equity

shareholders

Equity 10 x 0.20 0.80 1.20

Pref. 2 x 0.20 0.16 0.26 - 0.02

Debt 6 x 0.20 6 x 0.15 0.12 0.18

Total 13.60

Segments of Return on equity :

ESC funds ( 1.20 / 10 ) x 100 = 12.00%

Pref. Funds (-0.02/ 2 ) x 100 = - 0.20%

Debt. Funds (0.18 /10) x100 = 1.80%

Total 13.60 %

(ii) EBIT 3.60 Crores

Interest -0.90 Crores

EBT 2.70 Crores

EBIT

F. leverage = ----------------------------------------

EBT pre tax profit required to pay pref. dividend

3.60 Crores

= ----------------------------- = 1.5882

2.70 [(0.26) x (100/60)


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Combined Leverage = Operating Leverage x Financial leverage

4 = Operating leverage x 1.5882 Operating leverage = 2.5186

Q. No.2 :Q. No.2 :Q. No.2 :Q. No.2 :Operating leverage of an organization has been increased from 4 last year to 5

during the current year. Fixed overheads have increased by 5% during the current yearcompared to last year. Sales have also increased by 8% over last year. Assess to what

extent the profit of current year is likely to change over last year.

AnswerAnswerAnswerAnswer

Let contribution = 100 Let FC = x

Last year 4 = 100 / (100 x) FC = 75 profit = 25

This year FC = 78.755 = Cont / ( cont 78.50)

Cont. = 98.4375

Profit = 98.4375 78.75 = 19.6875

% change in profit = [(25 19.6875) / 25 ] x 100 = 21.25

Q. No. 3Q. No. 3Q. No. 3Q. No. 3:::: A firm has a sales of Rs. 6 crores, Variable cost Rs. 3.5 crores and

Fixed cost of Rs. 0.65 crores. The firm has debt and equity resources worth of

Rs.7 crores and 10 crores respectively. With the date given show:

(i) The firms ROI.(ii) EBIT if sales decline to Rs. 4 crores.(iii) If the industrys assets turnover is 4 times, does the firm has high or

low asset turnover ? The cost of debt is 10%, ignore taxation. (6(6(6(6

Marks) (NMarks) (NMarks) (NMarks) (Nov. 2006)ov. 2006)ov. 2006)ov. 2006)


Rs. Crores

Sales 6

VC 3.50

FC 0.65

EBIT 1.85

ROI = (1.85/17) x 100 = 10.88

Rs. Crores

Sales 4

VC 2.33

FC 0.65

EBIT 1.02

Assets turnover = sales / assets = 6/17 = .3529


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It is very low as compared to industry.

Q. No.4Q. No.4Q. No.4Q. No.4:::: Consider the following information:

EBIT Rs,1120 Lakhs PBT Rs.320 Lakhs Fixed Cost Rs.700 Lakhs.

Find the % change in EPS if sales increased by 5%. (Nov. 2001) (6 marks)(Nov. 2001) (6 marks)(Nov. 2001) (6 marks)(Nov. 2001) (6 marks)


Operating leverage = Contribution / EBIT

= 1820/1120 = 1.625

Financial leverage = EBIT / EBT = 1120/320 = 3.50

Composite leverage = 1.625 x 3.50 = 5.6875

Composite leverage = % change in EPS / % change in sales5.6875 =% change in EPS / 5

% change in EPS = 28.4375

Documents

Appendix C - Leverage