Unit 3 

LEVERAGES

3.1 INTRODUCTION

A company can raise funds required for investment either by increasing the owners’ claims or creditors’ claims. The claims of the owners increase when a company raises funds by issuing equity shares. The claims of the creditors increase when the funds are raised by borrowings. Thus, the various means used to raise the funds represent the capital structure of the company. The capital structure decision is of great importance for the management because it influences the debt-equity mix of the company which affects the shareholders’ return and risk. If the borrowed funds are more in the capital structure of a company, it results in an increase in shareholders’ earnings together with increase in their risk. It is because the cost of borrowed funds is less than that of the shareholders’. The costs on account of borrowed funds are allowable as a deduction for income-tax purpose. However, the borrowed funds carry a fixed rate of interest which has to be paid whether the company is earning profit or not. Thus, the risk of the shareholders increases in case there are a high proportion of borrowed funds in the total capital of a company. If the proportion of the shareholders’ funds is more than the proportion of the borrowed capital, the return as well as the risk of the shareholders will be less. The effect of financing or debt-equity mix on the shareholder’s earnings and risk can be examined by using the concept of leverage.

3.2 MEANING OF LEVERAGE

The term leverage refers to a relationship between two interrelated variables. It represents the influence of one financial variable over some other related financial variable. Leverage is used to describe the firm’s ability to use fixed cost assets or funds to magnify the return to its owners.

James Horne defined Leverage as “the employment of an asset or funds for which the firm pays a fixed cost or fixed return.”

Leverage results when a firm employs an asset or source of funds which has a fixed cost. There will be no leverage, if a firm is not required to pay a fixed cost. The fixed cost or return has to be paid or incurred irrespective of the volume of output or sales, the size of such cost or return has considerable influence on the amount of profits available for the shareholders.

When the volume of sales changes leverage helps in quantifying such influence. Thus, leverage can be defined as “relative change in profits due to a change in sales.” A high degree of leverage means large change in profits due to a relatively small change in sales. Thus, higher the leverage, higher is the risk and higher is the expected return.

3.3 TYPES OF LEVERAGE

There are three commonly used measures of leverage in financial analysis. These are as follows:

OPERATING LEVERAGE:

The operating leverage is defined as the employment of an asset with a fixed cost in the hope that sufficient revenue may be generated to cover all the fixed and variable costs. It can also be defined as “the tendency of the operating profit to vary disproportionately with sales.” It exists when the firm has to pay fixed cost regardless of volume of output or sales. Thus, operating leverage is a function of three factors:

• Fixed amount of cost.
• Variable contribution margin.
• Volume of sales.

The operating leverage can be calculated by using the following formula:

Operating leverage   = Contribution        

Operating Profit

= C/EBIT

Contribution   = Sales - Variable Cost.

Operating profit means Earnings before Interest and Taxes (EBIT).

Operating leverage is the ratio of net operating income before fixed charges to net operating income after fixed charges.

Degree of Operating Leverage:

The degree of operating leverage may be defined as a percentage change in the profits resulting from a percentage change in the sales. It can be put in the form of a formula as follows:

DOL =  Percentage change in net operating income

Percentage change in sales

Operating leverage is directly proportional to business risk. It indicates the impact of change in sales on operating income. If a firm has a high degree of operating leverage a small change in sales will have a large effect on operating income. The operating profits of such a firm will increase at a faster rate than the increase in sales. Similarly, the operating profits of such a firm will suffer a greater loss as compared to reduction in its sales. Generally, the firms should not operate under conditions of a high degree of operating leverage because it is a very risky situation where a small decline in sales will affect its profits.

Illustration 1:A company produces and sells 10,000 calculators. The selling price per calculator is Rs. 500. Variable cost per calculator is Rs. 200 and fixed operating cost is Rs. 20, 00,000. You are required to calculate:

1. Operating leverage.
2. If sales are up by 10%, what is its impact on EBIT?

Solution:

Statement of Profitability

1. Operating leverage (OL) = Contribution

EBIT

= 30,00,000

10,00,000

=3 times

b.     If sales are up by 10%:

OL    =   % in EBIT

% in sales

3  = X

10

X  = 30%

Thus, if sales are up by 10% the EBIT will increase by 30% (10 x 3) which is checked as follows:

Increase in EBIT = 3,00,000 x 100

10,00,000

= 30%

FINANCIAL LEVERAGE:

The financial leverage can be defined as “the tendency of the residual net income to vary disproportionately with operating profit. It may also be defined as the use of funds with a fixed cost in order to increase earnings per share of the company.” The financial leverage indicates the change that takes place in the taxable income as a result of change in the operating income. It signifies the existence of fixed interest bearing securities in the capital structure of the company. Financial leverage induces the use of funds obtained at a fixed cost in the hope of increasing the return to

The equity shareholders. The financial leverage can be computed using the following formula:

Financial leverage =   EBIT     

EBT

Where, EBIT is the Earnings before Interest and Taxes. EBT is the Earnings before Tax.

Degree of Financial Leverage (DFL) is the ratio of the percentage change in earning before tax to the percentage increase in operating profit i.e. EBIT. This can be put in the following formula:

DFL =        Percentage change in taxable income    

Percentage change in the operating income

According to Gitman, “financial leverage is the ability of a firm to use fixed financial charges to magnify the effects of changes in EBIT on the company’s earnings per share.” Thus, the financial leverage indicates the percentage change in earning per share in relation to a percentage change in EBIT. Accordingly, the degree of financial leverage can be calculated as per the following formula:

DFL = Percentage change in EPS

Percentage change in EBIT

There will be no financial leverage if the result of the above equation is less than 1.

Financial leverage is also termed as ‘Trading on Equity’. The concept of trading on equity states that the company uses equity capital as well as borrowed capital while deciding its capital structure. The objective of the term trading on equity is to provide a higher return to the shareholders of the company. However, trading on equity should be used for the term financial leverage only when the financial leverage is favorable. The financial leverage has potentiality of increasing the return to equity shareholders but at the same time it creates additional risk for the shareholders also.

Illustration 2:

Z Ltd. Has given the following details:

It has borrowed Rs. 10,00,000 @ 15% p.a. And its equity share capital is Rs.10,00,000

You are required to calculate:

1. Operating leverage.
2. Financial leverage.

Solution:

Income Statement:

1. Operating leverage (OL) = Contribution 

EBIT

= 24,00,000

12,00,000

= 2 times

b.     Financial leverage (FL) = EBIT 

EBT

= 12,00,000

10,50,000

= 1.14 times

COMBINED LEVERAGE:

Combined leverage expresses the relationship between revenue on account of sales and the taxable income. It may be defined as “the potential use of fixed costs, both operating and financial which magnifies the effect of sales volume on the earnings per share of a company.” Thus, degree of combined leverage is the ratio of percentage change in earning per share to the percentage change in sales. It indicates the effect of the change in sales on earning per share.

Operating leverage and financial leverage are closely concerned with the firm’s capacity to meet its fixed costs, both operating and financial. If both the leverages are combined, the result obtained will disclose the effect of change in sales over change in taxable profit. Combined leverage can also be called as composite leverage. It helps to find out the resulting change in taxable income due to change in sales. The following formula can be used to find out combined leverage:

Combined leverage = Operating Leverage x Financial Leverage

= Contribution/ EBIT

Contribution/EBT

= EBIT/EBT

The degree of combined leverage can also be calculated as follows:

DCL =Percentage change in EPS

Percentage change in sales

Degree of combined leverage indicates the effect of change in sales on the earning per share.

Illustration 3:

The Income Statement of CRL Ltd. Is given below: You are required to calculate

1. Operating leverage,
2. Financial leverage, and
3. Combined leverage.

Income Statement for the year ended 31-12-2008

Solution:

Income Statement for the year ended 31-12-2008

1. Operating leverage (OL) = Contribution 

EBIT

= 6,00,000

5,00,000

= 1.2 times

b.     Financial leverage (FL) = EBIT 

EBT

= 5,00,000

3,60,000

=1.39 times

c.      Combined Leverage = OL x FL

= 1.2 x 1.39

= 1.67 Times

3.4 SIGNIFICANCE OF LEVERAGE

Leverages are the tools used by the financial experts to measure the return to the owners. The financial leverage is considered to be superior of these tools. Financial leverage focuses the attention on the market price of the share. The management of a company always tries to increase the market price of the shares by increasing the net worth of the company. Therefore, the management resorts to trading on equity in order to increase EBIT and then the corresponding increase in the price of the equity shares.

A company has to keep the balance between the two leverages because they have got tremendous effect on EBIT and EPS. A right combination between the two leverages is a very big challenge for the company managements. A proper combination of both operating and financial leverages is a blessing for the company’s growth. However, an improper combination may prove to be a curse. Financial or operating leverages exist only when the result of the calculation is more than one.

A high degree of operating leverage together with a high degree of financial leverage makes the position of the company very risky. In this case, a company employs excessively assets for which it has to pay fixed costs and at the same time it uses a large amount of debt capital. The fixed costs for using assets and fixed interest charges bring a greater risk to the company. If the earnings fail, the company may not be in a position to meet its fixed costs. Greater fluctuations in earnings are likely to occur on account of the existence of a high degree of operating leverage. The existence of high degree of operating leverage will result in a more than proportionate change in operating profits even on account of small change in sales. The presence of a high degree of financial leverage causes more than proportionate changes in EPS even on account of a small change in EBIT. Thus, a company having a high degree of financial leverage and a high degree of operating leverage has to face the problems of inadequate liquidity or even insolvency in one or the other way. However, lower leverages indicate the cautious policy of the management but the firm may be losing many profit-earning opportunities. Therefore, a company should make all possible efforts to combine the operating and financial leverage in a way that suits the risk-bearing capacity of the company. Thus, a company with high operating leverage should have low financial leverage so that the combined leverage may be ideal. Similarly, a company having a low operating leverage will stand to gain by having a high financial leverage provided it has enough profitable opportunities for the employment of borrowed funds. Low operating leverage and a low financial leverage is considered to be an ideal situation for the maximization of the profits with minimum of risk.

3.5 EBIT-EPS ANALYSIS

EBIT-EPS analysis gives a scientific basis for comparison among various financial plans and shows ways to maximize EPS. Hence EBIT-EPS analysis may be defined as ‘a tool of financial planning that evaluates various alternatives of financing a project under varying levels of EBIT and suggests the best alternative having highest EPS and determines the most profitable level of EBIT’.

Concept of EBIT-EPS Analysis:

The EBIT-EBT analysis is the method that studies the leverage, i.e. comparing alternative methods of financing at different levels of EBIT. Simply put, EBIT-EPS analysis examines the effect of financial leverage on the EPS with varying levels of EBIT or under alternative financial plans.

It examines the effect of financial leverage on the behavior of EPS under different financing alternatives and with vary­ing levels of EBIT. EBIT-EPS analysis is used for making the choice of the combination and of the vari­ous sources. It helps select the alternative that yields the highest EPS.

We know that a firm can finance its investment from various sources such as borrowed capital or equity capital. The proportion of various sources may also be different under various financial plans. In every financing plan the firm’s objec­tives lie in maximizing EPS.

Advantages of EBIT-EPS Analysis:

We have seen that EBIT-EPS analysis examines the effect of financial leverage on the behavior of EPS under various financing plans with varying levels of EBIT. It helps a firm in determining optimum financial planning having highest EPS.

Various advantages derived from EBIT-EPS analysis may be enumerated below:

1. Financial Planning:Use of EBIT-EPS analysis is indispensable for determining sources of funds. In case of financial planning the objective of the firm lies in maximizing EPS. EBIT-EPS analysis evalu­ates the alternatives and finds the level of EBIT that maximizes EPS.

2.     Comparative Analysis:EBIT-EPS analysis is useful in evaluating the relative efficiency of depart­ments, product lines and markets. It identifies the EBIT earned by these different departments, product lines and from various markets, which helps financial planners rank them according to profitability and also assess the risk associated with each.

3.     Performance Evaluation:This analysis is useful in comparative evaluation of performances of various sources of funds. It evaluates whether a fund obtained from a source is used in a project that produces a rate of return higher than its cost.

4.     Determining Optimum Mix:EBIT-EPS analysis is advantageous in selecting the optimum mix of debt and equity. By emphasizing on the relative value of EPS, this analysis determines the optimum mix of debt and equity in the capital structure. It helps determine the alternative that gives the highest value of EPS as the most profitable financing plan or the most profitable level of EBIT as the case may be.

Limitations of EBIT-EPS Analysis:

Finance managers are very much interested in knowing the sensitivity of the earnings per share with the changes in EBIT; this is clearly available with the help of EBIT-EPS analysis but this technique also suffers from certain limitations, as described below

1. No Consideration for Risk:Leverage increases the level of risk, but this technique ignores the risk factor. When a corporation, on its borrowed capital, earns more than the interest it has to pay on debt, any financial planning can be accepted irrespective of risk. But in times of poor business the reverse of this situation arises—which attracts high degree of risk. This aspect is not dealt in EBIT-EPS analysis.

2.     Contradictory Results:It gives a contradictory result where under different alternative financing plans new equity shares are not taken into consideration. Even the comparison becomes difficult if the number of alternatives increase and sometimes it also gives erroneous result under such situation.

3.     Over-capitalization:

This analysis cannot determine the state of over-capitalization of a firm. Beyond a certain point, additional capital cannot be employed to produce a return in excess of the payments that must be made for its use. But this aspect is ignored in EBIT-EPS analysis.

Illustration 4:A company is contemplating to raise additional fund of Rs. 20,00,000 for setting up a project. The company expects, EBIT of Rs. 8,00,000 from the project.  Following alternative plans are available:

(a)         To raise Rs. 20,00,000 by way of equity share of Rs. 10 each

(b)        To raise Rs. 10,00,000 by way of equity shares and Rs. 10,00,000 by way     of debt @ 10%.

(c)         To raise Rs. 6,00,000 by way of equity and rest Rs. 14,00,000 by way of preferences shares @ 14%.

(d)        To raise Rs. 6,00,000 by equity shares, Rs. 6,00,000 by 10% Debt, Rs. 8,00,000 by 14% Preference shares

The company is in 60% tax bracket which option is best?

Solution:

EBIT-EPS Analysis