LEVERAGEPARVESH AGHI

MeaningThe dictionary meaning of the term

leverage refers to an ‘increase means of accomplishing purpose”.

In machines leverages means the instrument that helps us in lifting heavy objects, which may not be otherwise possible.

This concept is valid in business too. In Financial management ,it is used to describe the firm’s ability to use fixed assets costs to satisfy to magnify the returns of its owners

DefinitionLeverage is the ratio of the net

rate of return on the shareholder’s equity and net rate of return on total capiatlisation”

Type of LeverageThere are three types of

leverages1. Financial leverage2. Operating leverage3. Composite leverage

Financial leverageA firm needs funds to run and

manage its activities. The funds are first needed to set a business and then to implement an expansion , diversification and other plans. A decision has to be made regarding the compositions of funds. The funds may be raised through two sources, owners , called owners equity and outsiders , called debt equity

“Financial leverage exists whenever a firms has debts as sources of funds that carry a fixed charges”

Computation of financial leverageWhere capital structure consists

of equity shares and debts.Financial leverage= EBIT EBT = EBIT EBIT-INT

When capital structure consists of equity shares , preference shares and debt

FL= EBIT EBIT-INT-(PDX1/1-t)

Degree of Financial leverageDFLDFL = % change of EPS % change in EBIT

Operational LeverageThis leverage is associated with

employment of fixed costs assets, it is calculated to know income of the company on different levels of sales.

It is a measure of effect on operating profit of the concern on change in sales

Operational LeverageOL= Contribution EBIT

Contribution= Sales – variable costEBIT = Contribution- fixed

cost

Degree of operating leverage

DOL= %Change in EBIT % Change in Sales

Composite LeverageComposite leverage is calculated

to determine the combined effect of operating and financial leverage

CL= Financial Lev X Operating lev

CL= EBIT X Contribution EBT EBIT= Contribution EBT

Degree of Composite leverage

DCL= % Change in EBT % Change in Sales

ExampleCalculate financial , operational

and composite leverage from following data

Sales 1,00,000 units @2/- Per unit

Variable Cost per unit @.70 per unit

Fixed Cost Rs 1,00,000Interest charges on debt Rs

3668

Sales 1,00,000 2 2,00,000

Variable cost

1,00,000 .7 70,000

Contribution

1,30,000

Fixed Cost 1,00,000

EBIT 30,000

Interest 3368

EBT 26,632

Financial lev

EBIT/EBT 30000/26632 1.126

Operational lev

C/EBIT 1,30,000/30000

4.33

Composite C/ EBT 1,30,000/26632

4.88

DFL

DOL

DCL %C in EBT/ %Cin Sales

FL= EBIT/EBTOP=C/EBITCL= C/EBT