DIFFERENT BETWEEN OPERATING LEVERAGE AND FINANCIAL LEVERAGE

Operating LeverageFinancial Leverage1-Operating leverage is associated with

investment activities of the company.

2 .Operating leverage consists of fixed operating expenses of the company.

3 .It represents the ability to use fixed operating cost.

4 .Operating leverage can be calculated by DOL=C/OP

5 .A percentage change in the profits resulting from a percentage change in the sales is called as degree of operating leverage.

6 .Trading on equity is not possible while the company is operating leverage.

7 .Operating leverage depends upon fixed cost and variable cost.

8 .Tax rate and interest rate will not affect the operating leverage.

1 .Financial leverage is associated with financing activities of the company.

2 .Financial leverage consists of operating profit of the company.

3 .It represents the relationship between EBIT and EPS.

4 .Financial leverage can be calculated by FL= EBIT/EBIT-C

5 .A percentage change in taxable profit is the result of percentage change in EBIT.

6 .Trading on equity is possible only when the company uses financial leverage.

7 .Financial leverage depends upon the operating profits.

8 .Financial leverage will change due to tax rate and interest rate.

COMBINED LEVERAGEWhen the company uses both financial and operating leverage to magnification of anychange in sales into a larger relative changes in earning per share.

Combined leverage is also called as composite leverage or total leverage.

Combined leverage express the relationship between the revenue in the account of sales and the taxable income.

Combined leverage can be calculated with the help of the following formulas:DCL = DOL × DFL

COMBINED LEVERAGEDCL = Q(P-VC) × Q(P-VC)- FC

Q(P-VC)- FC Q(P-VC)-FC –CDCL = Q(P-VC)

Q(P-VC) – FC-CExample:

Sales in units = 250000

Selling price per unit= $2.5Variable cost per unit = $1.8 Fixed cost = 42000Debenture (interest at 10%) =$180000Profit of preferred share capital =$6000the company is in 25% tax.

Required : compute the following 1 - break-even point in units and dollars.

2 -DOL 3- DFL 4- DCL

DCL•Solution:

break-even point in units = Fixed cost = 42000 60000

) P-VC) (2.5-1.8(

break-even point in dollars = 60000 × 2.5 = $150000.

2 -DOL = Q(P-VC) =250000(2.5 -1.8) = 1.315

Q(P –VC) –FC 250000(2.5-1.8) -42000

3 -DFL = Q×( P-VC) –FC = 250000(2.5 -1.8) -42000

Q×( P-VC) –FC – C 250000(2.5 -1.8) -42000-18000-(6000÷(1-%25))

DFL = 1.242

DCL = Q(P-VC) = 250000(2.5 -1.8

Q(P-VC) – FC-C 250000 (2.5-1.8)-42000 –(6000÷(1-%25)) = 1.633

OR

DCL = DOL × DFL = 1.315 × 1.242 =1.633

Exercise

Kumar company has sales of $. 2,500,000. Variable cost of $ 1,500,000 and fixed cost of $. 500,000 and debt of $. 12,50,000 at 8% rate of interest. Calculate combined leverage.

SolutionCombined leverage =Operating leverage× Financial leverage

DOL = (2500000 -1500000) ÷ (2500000 -1500000 -500000)

=2

DFL = (2500000-1500000-500000) ÷(2500000-1500000-500000-100000 ) =1.25

DCL = 2 × 1.25 = 2.5

Uses Combined leverage to predict EBIT

•We can use combined leverage to predict earning before interest and tax EBIT, and earning per share EPS.

•Expected EBIT = (1+(DCL×%S)) ×Actual EBIT•Expected EPS = (1+(DCL×%S)) ×Actual EPS

•Example :Suppose that the actual sales for company x equal 1200000 $ and the expected sales in the coming year= 1296000 $ , and DOL = 2.4, DFL =1.6

Actual EBIT = %25 from net sales . Compute the expected EBIT.

• %S = (1296000-1200000)/1200000 = %8•Actual EBIT = %25 × 1200000 = 300000$

•DCL =DOL × DFL = 2.4 ×1.6 = 3.84•Expected EBIT = (1+(DCL×%S)) ×Actual EBIT

• Expected EBIT = (1+ (3.84×%8 ) ×300000 = 392160

•Example : •the expected sales is decrease %5 •DCL = 4 , and the actual EPS = 3.5

•Compute the expected EPS • .Expected EPS = (1+(DCL×%S)) ×Actual EPS

•Expected EPS = ( 1+ (4× - 5%)) × 3.5 = 2.8