CHAPTER SEVEN

LEVERAGE ANALYSIS
Learning Objectives:
After completing this chapter, you will be able to:
1. Acquire an understanding of leverage ratios
2. Examine the consequences of financial leverage for a business firm
3. Explain the concepts of financial and operating leverage and
examine the relationship between the two.
4. Assess the risk implication of financial leverage.
Leverage ratios, which reflect the solvency status of a firm, are covered here in detail.
Basic concepts of leverage and will be exposed to the role and effects of financial leverage.
• Consider for a movement the common use of the term’s ‘level’ and ‘leverge’.
• “Lever’ is an inducing or compelling force.
• “Leverage’ is the action of a lever or the mechanical advantage gained by it; it also
means ‘effectiveness’ or ‘power’.
• The common interpretation of leverage is derived from the use or manipulation of a tool
or device termed as lever which provides a substantive clue to the meaning and nature of
financial leverage.
• Now, suppose we suggest that our lever is the use of debt or borrowed funds in
financing the acquisition of assets.
• The GTB limited wants to purchase fixed assets worth $800,000 for the execution of a
project which was to be financed by raising share capital of $300,000 and term loan of
$500,000 @18% interest.
• The company was required to earn a minimum return of 20% on its share capital. Other
companies of this type were earning this much and unless GTB Limited provided at least
this return, no investor would be attracted to buy its shares. The GTB Limited pays tax at
40% and is not required to pay any tax on the interest charges on term-loans.
• What happens to the company’s net returns (after interest and taxes) on equity if: (a) the whole of
$800,000 is financed by selling share capital; and (b) the scheme of financing as envisaged in the problem
is implemented? You may assume GTB’s earnings power to be 40% (before interest and tax) on total
assets of $800,000 (i.e., $320,000; i.e., constant EBIT).
The net return on equity is 24% when no debt is used but it is 46% when debt is used. There
is a considerable increase in the net return. The effect which the use of debt funds
produces on returns is called financial leverage.
• The financial leverage measures the effects of the changes in EBIT on the EPS of the
company.
• The commonly used measures of financial leverage are:
a) Debt Ratio: This is the proportion of long-term debt in the total capital employed in the
business.
DR = D
D+E
Where: E = book value of equity (i.e., shareholders’ funds) D = book value of debt
• This ratio indicates the extent to which the firm relies on debt as a source of finance.
b) Debt-Equity Ratio: This is the ratio of long-term debt to the shareholders’ funds in the
capital structure of the firm.
D-E Ratio = D
E
Where: E = book value of equity (i.e., shareholders’ funds) D = book value of debt
• This ratio indicates the extent to which the firm relies on debt as a source of finance.
 c) Interest Coverage Ratio (ICR): This is measuring the ability of the firm to meet out its
interest payment obligations. In other words, the ability to pay the fixed financial charges.
ICR = EBIT
Interest
❑ Impact of Financial Leverage on Investor’s Return and Risk: the equity shareholders
are the residual claims on the earnings of the firm.
❑ Two measures of return that are important from the view point of shareholders are
earnings per share (EPS) and return on equity (ROE).
EPS = Profit After Taxes
Number of shares Outstanding
EPS = EBIT –I) (1 – T)
N
ROE = Profit After Taxes
Shareholders’ funds
• In a large number of situations, a firm would be in a position to exercise a degree of
control on the choice of its technology and the related production processes.
• The production processes which are accompanied by high fixed costs but low variable
costs are generally the highly mechanized and automated processes.
• With such processes, the degree of operating leverage if generally high, the break-even
point is relatively higher, and thus changes in the sales levels have a magnified (or
“leveraged”) effect on profits.
• Operating leverage refers to the use of fixed costs in the operation of a firm. In other
words, it implies the proportion of fixed costs in the total cost structure of the firm.
• The higher the proportion of fixed costs in the total cost structure the higher is the
operating leverage.
• Fixed operating costs do not include debt interest, which is fixed financial cost.
• On the other hand, it includes costs such as administrative costs, depreciation, selling and
advertising expenses, etc. if there are no fixed costs, the firm has no operating leverage.
• Operating leverage is to measure operating risk. The risk arising out of variability in
earnings due to change in quantity produced and sold.
• Operating leverage means, in simple language, the change in Earnings Before Interest and
Tax (EBIT) because of change in Q (quantity produced and sold).
Measure of operating leverage
• Fixed Costs/Total Cost Ratio: operating leverage as the proportion of fixed costs in the
total cost structure, the ratio of fixed costs to total costs can be used as a measure of
operating leverage.
Operating Leverage = Fixed Costs
Total Costs
• Impact of Operating Leverage on Operating Profits: Operating profits of a highly
levered firm would increase at a faster rate for any given increase in sales.
• However, if the sales decline a firm with higher operating leverage would suffer more
loss than a firm with low operating leverage.
• When sales are increasing, the fixed costs can easily be provided for and the remaining
sales revenue goes towards increasing the operating of the firm (assuming that the
variable cost to sales ratio of the firm is less than 1).

Illustration:
There are two firms A and B manufacturing similar product. The selling price is $8 per unit.
The variable costs of A and B are respectively $6 and $4. The fixed costs are $20,000 and
$80,000 respectively. What is the effect on profit if the sales change from 20,000 to 40,000
units? What happens if the sales decline to 10,000 units?
•
Firm A Firm B
Sales (in units) 10,000 20,000 40,000 10,000 20,000 40,000
Sales Revenue (in $) 80,000 160,000 320,000 80,000 160,000 320,000
Variable Costs (in $) 60,000 120,000 240,000 40,000 80,000 160,000
Contribution (in $) 20,000 40,000 80,000 40,000 80,000 160,000
Fixed Costs (in $) 20,000 20,000 20,000 80,000 80,000 80,000
Profits (in $) 0 20,000 60,000 -40,000 0 80,000
• It is clear from the above illustration that an increase in sales with high operating
leverage leads to a greater increase in profits than that of a firm with lower
operating leverage. However, if the sales decline a firm with higher operating
leverage losses more than a firm with lower degree of operating leverage.
 Degree of Operating Leverage
• The responsiveness of operating income to change in sales is measured by the degree
of operating leverage (DOL).
• The Degree of operating leverage (DOL) is defined as the percentage change in the
earnings before interest and taxes relative to a given percentage change in sales.

% Change in EBIT
DOL =
% Change in Sales
 EBIT/EBIT
DOL =
 Sales/Sales
• What happens to profitability as the firm’s sales go from $160,000 (80,000 units) to
$200,000 (100,000 units), i.e. an increase of 25% in sales.

•
We will now consider what happen to operating income as volume moves from 80,000
to 100,000 units. We will compute the degree of operating leverage using the above
formula.
$24,000 𝑥 100
DOL = ΔEBIT/EBIT = $36,000
ΔS/S 20,000 𝑥 100
80,000

DOL = 67% = 2.67 times

25%
• Thus, for a 25% increase in output, operating profit will by 67% for Harding
Company. In other words, every 1 % increase in sales volume will be reflected in
a 2.67% increase in operating profits.
 Degree of Financial Leverage
• Degree of financial leverage measures the effect of a change in one variable on another
variable.
• DFL may be defined as the percentage change in earnings (EPS) that occurs as a result
of a percentage change in earnings before interest and taxes EBIT).
DFL = Percentage change in EPS
Percentage change in EBIT
DFL = ΔEPS/EPS
ΔEBIT/EBIT
$1.50 𝑥 100
DFL = ΔEPS/EPS = $1.50
ΔEBIT/EBIT 24,000 𝑥 100
36,000
DFL = 100% = 1.50 times
67%
 Degree of Combined Leverage
• DCL uses the entire income statement and shows the impact of a change in sales or volume on bottom-line earnings
per share. what happens to profitability as the firm’s sales go from $160,000 (80,000 units) to $200,000 (100,000
units), i.e. an increase of 25% in sales.
The formula for degree of combined leverage is stated as:
DCL = Percentage change in EPS
Percentage change in Sales
DCL = ΔEPS/EPS
ΔS/S
Using data from Table 5-2:
$1.50 𝑥 100
DCL = ΔEPS/EPS = $1.50
ΔS/S $40,000 𝑥 100
$160,000
DCL = 100% = 4 times
25%
Every percentage point change in sales will be reflected in a 4 percent change in earnings per share at this
level of operation.
 Degree of Financial Leverage
• Thus, for a 67% increase in operating income, taxable income as well as earnings per
share will increase by 100% for Harding Company.
• For purposes of computation, the formula for DFL may be conveniently restated as:
• DFL (at the starting point) = Operating Income = Q (P – VC – FC)
• Taxable Income Q (P – VC – FC) – I
Let’s compute the degree of financial leverage for Harding Company previously
presented in Table 5-2, at an operating income (EBIT) level of $36,000. The firm calls for
$12,000 of interest at all levels of financing.

DFL = EBIT = $36,000 = $36,000 = 1.5 times

EBIT – I $36,000 - $12,000 $24,000
At an EBIT level of $36,000, a 1 percent increase in operating income will produce a 1.5
percent increase in taxable income as well as in earnings per share (EPS).
 Degree of Financial Leverage
• An algebraic statement of the formula is:
DCL (at the starting point) = Contribution = Q (P – VC)
Taxable Income Q (P – VC – FC) – I
DCL = 80.000 ($2.00 - $0.80)
80,000 ($2.00 - $0.80) - $60,000 - $12,000
= 80.000 ($1.20)
80,000 ($1.20) - $72,000
= $96,000
$96,000 - $72,000
= $96,000
$24,000
DCL = 4 times (or)
The degree of combined leverage (DCL) may be measured by using the following formula:
DCL = DOL X DFL
DCL = (% change in EBIT) x (% change in IBT)
(% change in Sales) x (% change in EBIT)
= 2.67 X 1.50
= 4 times
THE END