Operating Leverage

Uses of Operating LeverageOperating leverage is one of the techniques to measure the impact of changes in sales which lead for change in the profits of the company.

If any change in the sales, it will lead to corresponding changes in profit.

Operating leverage helps to identify the position of fixed cost and variable cost.

Operating leverage measures the relationship between the sales and revenue of the company during a particular period.

Operating leverage helps to understand the level of fixed cost which is invested in the operating expenses of business activities.

Operating leverage describes the over all position of the fixed operating cost.

Uses Operating leverage to predict EBIT

Expected EBIT = (1+(DOL×%S)) ×Actual EBIT

%S , is percentage degree in sales

Example1 :

Suppose that the actual sales for company x equal 1600000 $ and the expected sales in the coming year= 2000000 $ , and DOL = 1.8 , Actual EBIT = %22

from net sales .

Compute the expected EBIT.

%S = (2000000-1600000)/1600000 = %25

Actual EBIT = %22 × 1600000 = 352000$

Expected EBIT = (1+(1.8×%25)) ×352000 = 510400

•Example2 : if EBIT = $50000 , DOL = 2 , and the expected sales is decrease %10, Compute

the expected EBIT. •Example3

•If EBIT is Loss $100000 , DOL = -3 , the expected sales increase %15 Compute the expected EBIT

•Solution Example 2 •Expected EBIT = (1+(2×-%10)) ×50000 =

40000•Solution Example 3

•Expected EBIT = (1+(-3×%15)) ×-100000 =-55000

FINANCIAL LEVERAGELeverage activities with financing activities is called financial leverage.

Financial leverage represents the relationship between the company’s earnings before interest and taxes (EBIT) or operating profit and the earning available to equity shareholders.

Financial leverage is defined as “the ability of a firm to use fixed financial charges to magnify the effects of

changes in EBIT on the earnings per share EPS.”

The use of long-term fixed interest bearing debt and preference share capital along with share capital is

called financial leverage or trading on equity.”

Financial leverage may be favorable or unfavorable depends upon the use of fixed cost funds.

Favorable financial leverage occurs when the company earns more on the assets purchased with the funds, then the fixed cost of their use. Hence, it is also called as positive financial leverage.

Unfavorable financial leverage occurs when the company does not earn as much as the funds cost. Hence, it is also called as negative financial leverage.

Degree of financial leverage may be defined as the percentage change in taxable profit as a result of percentage change in earning before interest and tax (EBIT).

Financial leverage can be calculated with the help of the following formula:

DFL = EBIT

EBIT – C Where,

DFL = Financial leverage

EBIT = Operating profit (EBIT)

C= cost of fund.

Degree of Financial Leverage

•DFL= Percentage change in taxable Income

• Percentage change in EBIT

Alternative Definition of Financial Leverage:

According to “financial leverage is the ability of a firm to use fixed financial changes to magnify

the effects of change in EBIT and EPS.”

DFL =EBIT

EPS

Where,

DFL = Financial Leverage

EBIT = Earning Before Interest and Tax

EPS = Earning Per share.

Financial Leverage

•Exercise:

A Company has the following capital structure.Equity share capital $1,00,000

8% Debentures $ 1,25,000

The present EBIT is $. 50,000.

Calculate the financial leverage assuring that the company is in 50% tax.

DFL = EBIT

EBIT – C

50000) ÷50000)– 125000×8% = ((1.25

Exercise:

A Company has the following capital structure. -EBIT $115000

-8% Debentures $ 300000-10% Prof. preferred share capital 250000

-the company is in 40% tax.DFL = EBIT

EBIT – CC = interest + preferred share capital profit before tax

C= %8× 300000 + ((250000 × %10)÷(1-%40))= =24000 + 41666.7= 65666.7

DFL = $115000÷115000- 65666.7 =2.33

DFL = Q×( P-VC) –FC

Q×( P-VC) –FC – C

Q: Quantity , P: Price , FC: Fixed cost , C: Cost of capital

Example :

Sales in units = 6000000

Selling price per unit 3.5

Variable cost per unit = 2

Fixed cost = 150000

Debenture (interest at 10%) =250000

Calculate DFL

DFL = 600000 (3.5-2)- 150000 = 1.0344

600000) 3.5-2- (150000 – 25000

Example:

EBIT = 140000$ ., Total equity = $400000 included 150000$ (preferred share equity (10%prof.), and the other is share equity (common share . 5$ per share ), calculate earning per share (EPS)

EPS = EBIT – Profit for preferred share

Total number of share equity

EPS = 140000 – (150000 ×%10) = 125000 =2.5

) 400000 – 150000 /(5 50000

Uses of Financial LeverageFinancial leverage helps to examine the relationship between EBIT and EPS.

Financial leverage measures the percentage of change in taxable income to the percentage change in EBIT.

Financial leverage locates the correct profitable financial decision regarding capital structure of the company.

Financial leverage is one of the important devices which is used to measure the fixed cost proportion with the total capital of the company.

If the firm acquires fixed cost funds at a higher cost, then the earnings from those assets, the earning per share and return on equity capital will decrease.

The impact of financial leverage can be understood with the help of the following exercise.

Example :

XYZ Ltd. decides to use two financial plans and they need $. 50,000 for total investment

ParticularsPlan APlan B

Debenture (interest at 10%)

Equity share ($. 10 each)

Total investment needed

Number of equity shares

40,000

10,000

50,000

1,000

10,000

40,000

50,000

4,000

The earnings before interest and tax are assumed at $. 5,000, and 12,500. The tax rate is 50%. Calculate the EPS.

•Solution•When EBIT = $5000

ParticularsPlan APlan BEarnings before interest and tax (EBIT)

Less : Interest on debt (10%)

Earnings before tax (EBT)

Less : Tax at 50%

Earnings available to equity shareholders.

No. of equity shares

Earnings per share (EPS)

Earnings/No. of equity shares

5,000

4,000

1,000

500

.500$

1,000

.$0.50

5,000

1000

4000

2000

2000$

4000

0.50$

•When EBIT is. 12,500

ParticularsPlan APlan BEarnings before interest and tax (EBIT)

Less : Interest on debt (10%)

Earnings before tax (EBT)

Less : Tax at 50%

Earnings available to equity shareholders.

No. of equity shares

Earnings per share (EPS)

Earnings/No. of equity shares

12500

4,000

8500

4250

.4250$

1,000

.$4.25

12500

1000

11500

5750

5750$

4000

1.44$