Leverage Analysis

Leverage reflects the responsiveness or influence of one financial variable over some other financial variable. The relationship between sales revenue and EBIT is defined as operating leverage and the relationship between EBIT and EPS is defined as financial leverage. The direct relationship between the sales revenue and the EPS can be established by combining the operating leverage and financial leverage and is defined as combined leverage.

Operating Leverage / Degree of Operating Leverage (DOL)

It measures the effect of change in sales revenue on the level of EBTT. DOL is calculated by dividing percentage change in EBIT by percentage change in sales revenue. It refers to firm’s position or ability to magnify the effect of change in sales over the level of EBIT. The level of fixed costs, which is instrumental in bringing this magnifying effect, also determines the extent of this effect. Higher the level of fixed costs in relation to variable cost, greater would be the DOL.

DOL = Percentage Change in EBIT ÷ Percentage change in Sales revenue

It is also calculated as a ratio of contribution to EBIT.

DOL = Contribution ÷ EBIT

Financial Leverage or Degree of Financial Leverage (DFL)

It measures degree of responsiveness change in EPS due to change in EBIT and is defined as Percentage change in EPS due to Percentage change in EBIT. Higher the level of fixed financial charges, greater will be DFL. It is also calculated as ratio of EBIT to EBT.

DFL = Percentage change in EPS ÷ Percentage change in EBIT

DFL = EBIT ÷ EBT

Degree of Combined Leverage (DCL)

DCL is product of DOL & DFL.

DCL = DOL × DFL

DCL = Percentage change in EPS ÷ percentage change in Sales revenue

DCL = Contribution ÷ EBT

Leverage Solved Problems

1. Calculate degree of operating leverage (DOL), degree of Financial leverage (DFL) and the degree of combined leverage (DCL) for the following firms and interpret the results.

Solution

Interpretation: High operating leverage combined with high financial leverage represents risky situation. Low operating Leverage combined with low financial leverage will constitute an ideal situation. Therefore, firm B is less risky because it has low fixed cost and low combined leverage.

2. A firm has sales of Rs. 12,00,000, variable cost of Rs. 8,00,000 and fixed costs of Rs. 2,00,000 and debt of Rs.5,00,000 at 10% rate of interest. What are the operating, financial and combined leverages? If the firm wants to double its earnings before interest and tax (EBIT), how much of a rise in sales would be needed on a percentage basis?

Solution

Since Operating Leverage is 2 times. Hence, 50 % increase in Sales would cause a 100 % increase in EBIT.

Verification:

3. Following information are related to four firms of the same industry:

Calculate (i) Degree of OL & (i) Degree of CL for all firms.

Solution

DOL = Percentage Change in EBIT ÷ Percentage change in Sales revenue

DFL = Percentage change in EPS ÷ Percentage change in EBIT

DCL = Percentage change in EPS ÷ percentage change in Sales revenue

4. X Corporation has estimated that for a new product its breakeven point is 2,000 units if the item is sold for Rs. 20 per unit; the cost accounting department has currently identified variable cost of Rs. 15 per unit. Calculate the degree of operating leverage for sales volume of 2,500 units and 3,000 units. What do you infer from degree of Operating Leverage at sales volumes of 2,500 units and 3,000 units and their difference if any?

Solution

At Break Even Point (BEP), EBIT = Fixed Cost & EBIT = 0

At the sales volume of 3000 units, EBIT is Rs. 5,000 which is double the EBIT of Rs. 2,500 (at sales volume of 2,500 units) because of the fact that the operating leverage is 5 times at the sales volume of 2,500 units. Hence, an increase of 20% in sales volume, EBIT has increased by 100% i.e., 5 times of 20%. At the level of 3000 units the operating leverage is 3 times. If there is change in sales from the level of 3,000 units, the % increase in EBIT would be 3 times as of  % increase in Sales volume.

5. The balance sheet of RBL Company is as follows:

The company’s Total Assets turnover ratio is 4, its Fixed operating costs are Rs. 5,00,000 and its Variable operating cost ratio is 40%. The income tax rate is 30%. Calculate for the Company the different types of leverages given that the face value of the share is 10.

Solution

Total Asset Turnover Ratio = Sales ÷ Total Asset

4 = Sales ÷ Rs. 4,00,000

Sales = Rs. 4,00,000 × 4 = Rs. 16,00,000

Variable Cost = 40 % of Sales

= 0.4 × Rs. 16,00,000 = Rs. 6,40,000

6. Following information is available with respect of two firms A & B:

You are required to calculate different leverages for both the firms and also comment on their relative risk position.

Solution

Degree of operating leverage is higher in case of B Ltd. and hence it has higher degree of operating or business risk. However, both the companies have same degree of financial leverage. Hence, both companies have same financial risk. Degree of combined leverage of B Ltd. is 3.5 and is higher than A Ltd. Thus. A Ltd seems to have lower risk as compared to B Ltd.

7. The Karnal Recreation Ltd. manufactures a full line of lawn furniture. The average selling price of a finished unit is Rs. 3,500 and variable cost is Rs. 2,500 per unit. Fixed cost for the company is Rs. 50,00,000 per year.

(i) What is break-even point in units for the company?

(ii) Find the degree of operating leverage at the following production and sales levels: 4,000 units; 5,000 units; 6,000 units; 8,000 units.

(iii) Does the degree of operating leverage increase or decrease as the production and sales levels rise above the break-even point? What conclusion would you draw from such increase or decrease?

(iv) By what percentage EBIT will increase if the company’s sales increase by 10% from the production and sales level of 8,000 units?

Solution

(i) Break Even Point = Fixed Cost ÷ Contribution per Unit

= 50,00,000 ÷ 1,000 = 5,000 Units

Contribution per Unit = Sales per Unit – Variable Cost per Unit

Rs. 3,500 – Rs. 2,500 = Rs. 1,000

iii. When the sales level rises above the break-even level, DOL decreases, which indicates that when sales increases beyond

Break-even level, the increase in operating profits (EBIT)

becomes lesser and lesser.

IV. In case sales increases by 10% from 8000 level, the EBIT will increase by 10 x 2.667=26.67% which can be verified from the table. The EBIT increases to Rs. 38,00,000 from Rs 30,00,000 i.e., an increase of 26.67%.

8. The capital structure of RBL Ltd. consists of ordinary share capital of Rs. 15,00,000 (shares of Rs. 100 each) and Rs. 15,00,000 of 10% debentures. The selling price is Rs. 12 per unit; variable costs amount to Rs. 7 per unit and fixed expenses amount to Rs. 2,50,000. The income tax rate is assumed to be 30%. The sales level is expected to increase from 1,00,000 units to 1,20,000 units. Calculate:

(i) The percentage increase in earnings per share;

(ii) The degree of financial leverage at 1,00,000 units and 1,20,000 units.

(iii) Comment on the behaviour of Operating and Financial leverages in relation to increase in production from 1,00,000 units to 1,20,000 units.

Solution

iii. As a result of increase in sales from 1,00,000 units to 1,20,000 units (20% increase), both the financial leverage and operating leverage have decreased which signifies that business risk and financial risk of the business has been reduced.

9. The data relating to two companies are as given below:

You are required to calculate the Operating leverage, financial leverage and combined leverage of two Companies.

Solution

10. The following information is available for ABC & Co.

Calculate % change in EPS if the sales are expected to increase by 5 %.

Solution

Contribution = EBIT + Fixed Cost

= Rs. 10,00,000 + Rs. 5,00,000 = Rs. 15,00,000

Combined Leverage = Contribution ÷ EBT

= 15,00,000 ÷ 6,00,000 = 2.5

Combined Leverage = %age Change in EPS ÷ %age in Sales

2.5 = %age Change in EPS ÷ 5

%age change in EPS = 5 × 2.5 = 12.5 %

There will be a 12.5 % increase in EPS if sales increase by 5 %.

11. RBL Ltd. has three financial plans before it, Plan I, Plan II and Plan III. Calculate operating and financial leverage for the firm on the basis of the following information and also find out the highest and lowest value of combined leverage:

Solution

The calculation of combined leverage shows the extent of the total risk and is helpful to understand the variability of EPS as a consequence of change in sales levels. In this case, the highest combined leverage is there when Financial Plan III is implemented in situation C; and lowest value of combined leverage is attained when Financial Plan II is implemented in situation A.

12. The share capital of a company is Rs. 10, 00,000 having face value of Rs. 10 each. The company has debt capital of Rs. 5, 00,000 at 10% rate of interest. The sales of the firm are 3,00,000 units per annum at a selling price of Rs. 5 per unit and variable cost is Rs. 3 per unit. The fixed cost amounts to Rs. 2,50,000. The company pays tax at 40 %. If the sales increase by 10%, calculate:

(i) Percentage Increase in EPS.

(ii) Degree of Operating Leverage at the two levels; and

(iii) Degree of Financial Leverage at the two levels.

Solution

Alternate Method

DCL = Contribution ÷ EBT

= 6,00,000 ÷ 3,00,000 = 2 or

DCL = DOL × DFL = 1.714 × 1.17 = 2

DCL = Percentage Change in EPS ÷ Percentage Change in sales

2 = Percentage Change in EPS ÷ 10

Percentage Change in EPS = 10 × 2 = 20 %

13. i. Find out Operating Leverage from the following data:

(ii) Find out the Financial Leverage from the following data:

Solution: i.

ii. Net Worth = Shareholders’ Fund = Rs. 30,00,000

Debt / Equity Ratio = Debt ÷ Shareholders’ Equity

=> 3 = Debt ÷ Rs. 30,00,000

Debt = Rs. 30,00,000 × 3 = Rs. 90,00,000

EBT = EBIT or Operating Profit – Interest

= Rs. 20,00,000 – 10 % of Rs. 90,00,000 = Rs. 11,00,000.

DFL = EBIT ÷ EBT = 20,00,000 ÷ 11,00,000 = 1.82

14. The following are details of RBL Ltd. for the year ending 31.03.2021.

Prepare Income Statement of the Company.

Solution

DFL = EBIT ÷ EBT => 2 = EBIT ÷ (EBIT – I)

=> 2 × (EBIT – I) = EBIT => 2 EBIT – 2I = EBIT

Or, 2 EBIT – EBIT = 2I

So, EBIT = 2 × Rs. 25,00,000 = Rs.50,00,000

DOL = Contribution ÷ EBIT

3 = Contribution ÷ Rs. 50,00,000

Contribution = Rs. 50,00,000 × 3 = Rs. 1,50,00,000.

Since Variable Cost is 60 % of Sales, hence Contribution is 40 % of Sales.

Since, Sales = V.C. + Contribution

40 % or .4 of Sales = Rs. 1,50,00,000

Sales = Rs. 1,50,00,000 ÷ .4 = Rs. 3,75,00,000.

Variable cost = 60 % of Sales = 0.6 × Rs. 3,75,00,000

= Rs. 2,25,00,000

15. Following information is available in respect of RBL Ltd:

Prepare Income Statement and find out EPS.

Solution

DFL = EBIT ÷ EBT

=> 1.7 = EBIT ÷ (EBIT – I)

=> 1.7 EBIT – 1.7 I = EBIT

=> .7 EBIT = 1.7 × 8,000

=> EBIT = 13,600 ÷ .7 = Rs. 19,430

=> EBT = EBIT – I = Rs. 19,430 – Rs. 8,000 = Rs. 11,430

DOL = Contribution ÷ EBIT

=> 1.5 = Contribution ÷ 19,430

=> Contribution = 1.5 × 19,430 = Rs. 29,145

PV Ratio = Contribution ÷ Sales

=> 0.4 = 29,145 ÷ Sales

=> Sales = 29,145 ÷ 0.4 = Rs. 72,863

I = Interest Liability

16. The following data is available for XYZ Ltd:

Find out:

(i) Using the concept of Financial Leverage, by what percentage will the taxable income increase if EBIT increases by 10 %.

(ii) Using the concept of Operating Leverage, by what percentage will EBIT increase if there is 15 % increase in sales?

(iii) Using the concept of leverage, by what percentage will the taxable income increase if sales increase by 10 %. Also verify the results in view of the above figures.

Solution

(i) Using the concept of Financial Leverage, by what percentage will the taxable income increase if EBIT increases by 10 %.

DFL = EBIT ÷ EBT => 50,000 ÷ 35,000 = 1.43

If EBIT increases by 10 %

New EBIT = 50,000 + 10 % of 50,000 = Rs.55,000

New EBT = New EBIT – Interest = 55,000 – 15,000 = Rs. 40,000

Percentage Increase in taxable income if EBIT increase by 10 %

= [ (New EBT – Existing EBT) ÷ Existing EBT ] × 100

= [(40,000 – 35,000) ÷ 35,000] × 100

= [5,000 ÷ 35,000] × 100 = 14.29%

(ii) Using the concept of Operating Leverage, by what percentage will EBIT increase if there is 15 % increase in sales?

DOL = Contribution ÷ EBIT => 1,50,000 ÷ 50,000 = 3

DOL = Percentage Change in EBIT ÷ Percentage change in Sales

=> 3 = Percentage Change in EBIT ÷ 15

=> Percentage Change in EBIT = 15 × 3 = 45%

(iii) Using the concept of leverage, by what percentage will the taxable income increase if sales increase by 10 %. Also verify the results in view of the above figures.

Solution

DCL = Contribution ÷ EBT => 1,50,000 ÷ 35,000 = 4.3

If sales increase by 10 %, taxable income will increase by

4.3 × 10% = 43 %

Note: Percentage change in Contribution remains equal to Percentage Change in Sales as Variable Cost changes in same proportion in which percentage of Sales changes.

Verification of results in view of the above figures:

Percentage Change in Profitable Tax (EBT)

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