Leverage Analysis

Meaning of Leverage
The term leverage refers to an increased means of accomplishing some purpose. Leverage
is used to lifting heavy objects, which may not be otherwise possible. In the financial point
of view, leverage refers to the ability to use fixed cost assets or funds to increase the returns to
shareholders.
Generally, increases in leverage results in increased returns and risk; and decreases in
leverage results in decrease in returns and risk. The amount of leverage in the firm’s capital
structure (the mix of long-term debt and equity) can significantly affect its value by affecting
returns and risks.
Definition of Leverage
James Horne has defined leverage as,
“the employment of an asset or fund for which the firm pays a fixed cost or fixed return.”
According to professor M.C. Kuchhal
“Leverage may be defined as meeting a fixed cost or paying a fixed return for employing resources
or funds.”

To understand the concept of leverage it is essential to remember the following income

statement
Sales XXX
Less: Variable Cost XXX
Contribution +++
Less: Fixed Cost XXX
EBIT (Operating Profit) +++
Less: Interest XXX
EBT +++
Less: Tax XXX
EAT +++
Less: Preference Dividend XXX
Earning for equity shareholder +++
Divide: Number of equity shares XXX
EPS +++

Types of Leverage
1. Operating leverage: Operating leverage is concerned with the relationship between the
firm’s sales revenue and its earnings before interest and taxes, or EBIT (Operating profit).
Operating leverage is defined as the firm’s ability to use fixed operating costs to
magnify effects of changes in sales on its earnings before interest on tax.

𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛
OL =
𝐸𝐵𝐼𝑇
 Degree of Operating Leverage
The degree of operating leverage may be defined as percentage change in the EBIT
resulting from a percentage change in the sales. It can be calculated with the help of the
following formula:
Percentage change in 𝐸𝐵𝐼𝑇
DOL=
Percentage change in sales
High operating leverage is risky because of presence of high fixed operating cost. And a
small change in sales causes high fluctuations in company’s EBIT.

2. Financial leverage: Financial leverage is concerned with the relationship between the
firm’s EBIT and its EBT/EPS. It is defined as the firm’s ability to use fixed financial
charges to magnify the effects of charge in EBIT/operating profit on firm’s EBT and EPS.
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”. It involves the use of
funds obtained at a fixed cost in the hope of increasing the return to the shareholders. Fixed
financial charges include debenture and preference dividend.

𝐸𝐵𝐼𝑇
FL =
𝐸𝐵𝑇

If preference share and tax is given, then Financial leverage is calculated by taking into
account preference dividend after adjusting tax. The formula will be
𝐸𝐵𝐼𝑇
FL = 𝑃𝑑
𝐸𝐵𝑇 − 1−𝑡

Degree of Financial Leverage:

Degree of financial leverage may be defined as the percentage change in EBT/EPS as a
result of percentage change in earnings before interest and tax (EBIT). This can be
calculated by the following formula
Percentage change in 𝐸𝐵𝑇/𝐸𝑃𝑆
DFL=
Percentage change in EBIT
High financial leverage is risky because of presence of high fixed financial cost. And a
small change in EBIT causes high fluctuations in company’s EBT/EPS.

3. Combined/Total leverage is concerned with the relationship between the firm’s sales
revenue and EBT/EPS.

= OL × FL
or
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛
=
𝐸𝐵𝑇
 If preference share and tax is given, then Combined leverage is calculated by taking into
account preference dividend after adjusting tax. The formula will be
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛
FL = 𝑃𝑑
𝐸𝐵𝑇 −
1−𝑡

Degree of Combined Leverage:

The percentage change in a firm’s earning per share (EPS) results from one percent change
in sales. This is also equal to the firm’s degree of operating leverage (DOL) times its degree
of financial leverage (DFL) at a particular level of sales.

Percentage change in 𝐸𝐵𝑇/𝐸𝑃𝑆

DCL =
Percentage change in Sales

Summary:
Farmula Degree
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 Percentage change in 𝐸𝐵𝐼𝑇
Operating Leverage
𝐸𝐵𝐼𝑇 Percentage change in sales
𝐸𝐵𝐼𝑇 Percentage change in 𝐸𝐵𝑇
Financial Leverage
𝐸𝐵𝑇 Percentage change in EBIT
Financial Leverage
𝐸𝐵𝐼𝑇 Percentage change in 𝐸𝑃𝑆
if preference share
and tax is taken into 𝑃𝑑
𝐸𝐵𝑇 − 1 − 𝑡 Percentage change in EBIT
consideration
OL × FL
or Percentage change in 𝐸𝐵𝑇
Combined Leverage
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 Percentage change in Sales
𝐸𝐵𝑇
OL × FL
Combined Leverage
Or Percentage change in 𝐸𝑃𝑆
if preference share
and tax is taken into 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 Percentage change in Sales
consideration 𝑃𝑑
𝐸𝐵𝑇 − 1 − 𝑡