Impact of Leverage on Profitability

Presented By :Ashwani Kumar

(M.Com., JRF)

The Concept of Leverage

You can not easily move a large boulder.

The Concept of LeverageHowever, with the aid of a lever you can

move an object many times your size.

The Concept of LeverageThe longer the lever, the bigger the

rock you can move.

SalesOrEBIT

Leverage in Physics

EBITOrEPS

Depndent Variable

Indepndent Variable

Leverage in Finance

Fixed Cost

This concept of leverage is valid in business also

Leverage

Operating Leverage FinancialLeverage Combined Leverage

Study the impact of operating fixed cost

Study the impact of financial fixed cost

Study the impact of both type of fixed cost

Affects a firm’s business risk Affects a firm’s total risk

Affects a firm’s financial risk

% change in EBIT% change in Sales

% change in EBT% change in Sales

% change in EBT% change in EBIT

ContributionEBT

EBITEBT

ContributionEBIT

EPS

Operatingleverage

Mor

e th

en 1

%

EBITSales

1%

Sensitivity of operating profit to change in quantity sold.

Impact of Operating Leverage on Operating Profit

EPS

Financialleverage

EBITSales

Sensitivity of EPS to change in EBIT.

Impact of Financial Leverage on Shareholder Earning

1% Mor

e th

en 1

%

EPS

Financialleverage

OperatingProfitSales

Operatingleverage

1%

Mor

e th

en 1

%

Impact of Combined Leverage on Shareholder Earning

Particuler Old New Chnage % Change

Sales 2,00,000 2,20,000 20,000 10%(-) Vriable Cost = 10% of Sales 20,000 22,000 2,000 10%

Contribution 1,80,000 1,98,000 18,000 10%

(-) Fixed Cost Operating 1,20,000 1,20,000 - 0%EBIT 60,000 78,000 1,80,000 30%(-) Interest 45,000 45,000 - 0%EBT 15,000 33,000 1,80,000 120%(-) Tax (30%) 4,500 9,900 5,400 120%

EAT 10,500 23,100 12,600 120%

(-) Peferance Share Dividend 2,000 2,000 - 0%Earning Availbale For Equity Shareholders 8,500 21,100 12,600 148%

EPS (No. Of equity share = 100 ) 85 211 126 148%

Ope

rati

ng

Leve

rage

Fina

ncia

l L

ever

age

Combined

LeverageEffect of Earnings per Share of a 10 Percent Increase in Sales

Financial Leverage is Double-edged Sword

ROI> Kd = Positive / Favorable

ROI<Kd = Negative / Unfavorable

Example :-

ROI = 25% Kd = 15%

(ROI-Kd)10%

Surplus received to equity shareholder

Example :-

ROI = 10% Kd = 15%

(Kd-ROI)5%

Deficit born by equity shareholder

Financial Leverage of Companies in India

High Debt Low DebtCompany Debt Ratio Interest

Coverage Ratio

Company Debt Ratio Interest Coverage

Ratio

HDFC Ltd. 87% 1.52 Infosys 0% -

ICICIC Bank 69% 1.53 ITC 0% 175.95

SBI 63% 1.44 ONGC 0% 2038.25

Axis Bank 57% 1.56 HUL 0% 209.56

HDFC Bank 48% 1.63 TCS 1% 540.50

The Company Listed in Sensex in India