Leverage Analysis

Commerce
Financial Management
Lesson: Leverage Analysis
Author: Mr. Vinay Kumar,
College/Dept: Aryabhatta College
University of Delhi
Institute of Lifelong Learning, University of Delhi Page | 1

Table of Content:
1. Learning Objectives
2. Introduction
3. Concept of Leverage
4. Types of Leverage and their Calculation
4.1. Operating Leverage
4.2. Financial Leverage
4.3. Combined Leverage
5. Importance of Leverages
6. EBIT-EPS Analysis
7. Review Illustrations
Summary
Glossary
Exercises
References

1. Learning Objectives:
After reading this lesson, you should be able to:

understand the concept of leverage,
explain various types of leverages,
understand the relationship among various leverages,
identify the reasons for occurrence of financial ,operating and combined leverage,
appreciate the importance of leverage analysis in capital structure decisions,
compute various leverages using simple information.
2. Introduction:
Figure 1: Finance Manager
Every finance manager is faced with two important financial decisions to maximise
shareholders wealth. First, how much finance is needed? Second, how to raise the
finance through debt and equity capital? The first problem can easily be tackled with
proper estimation of long term financial needs of the company. Second problem of
raising the fund in different proportion is more difficult than the previous one. It basically
relates to determining capital structure of the firm.
Figure 2: Components of Capital Structure

There are two components of the capital structure viz., debt and equity. Both are
important and have their own merits and demerits. The use of debt and equity depends
upon numerous factors. The debt financing results in fixed financial charge on the
income of the firm but does not interfere in the decision making of the firm as debt
holders have no voting rights whereas equity does not involve any fixed financial charge
but results in division of the ownership right. Either of two financing source cannot be
good for a company in all circumstances. Therefore, finance manager needs to ascertain
and review from time to time the best suited proportion of debt and capital in its capital
structure. The best mix of debt and equity which leads to maximisation of shareholders
wealth through maximisation of market price of equity share is known as optimum
capital structure. There are two techniques to calculate the impact of debt and equity in
overall capital structure of the firm viz. EBIT-EPS analysis and leverage analysis.
Value Addition 1: Video

Benefits of Investing in Equity, Debt and Liquid Instruments
Click on the link below to gain an insight into the benefits of investing in equity, debt
and liquid instruments.
Source: https://www.youtube.com/watch?v=1Wke5W-4GcU
Value Addition 2: Know More

Debt vs. Equity
Click on the link below to know more about the advantages and disadvantages of debt
and equity.
Source:http://smallbusiness.findlaw.com/business-finances/debt-vs-equity-advantages-
and-disadvantages.html
3. Concept of Leverage:
In general terms, leverage means relationship between two interrelated variables. While
studying the concept of leverage, it is to be remembered that the two variables are
related to each other i.e., where one variable depends on the other variable. The
dependent variable is shown as a numerator whereas independent variable is shown as a
denominator. In financial world, these variables can be cost and profit, sales and profit,
EBIT-EPS, etc.
Therefore, leverage may be defined as a % change in one variable (dependent) divided

by % change in another variable (independent).
Alternatively, it can be shown as
Leverage = % Change in Dependent Variable

-------------------------------------------
% Change in Independent Variable
Thus, leverage may be defined as a % change in one variable because of % change in
some other interrelated variable. It can also be explained as a responsiveness of a
dependent variable due to a change in the independent variable.

For example, a firm is able to increase its sales revenue from Rs 10000 to Rs 20000 (i.e.
100% increase) in a particular month by increasing advertisement expenditure form Rs
2000 to Rs 3000 (20% increase). The leverage between the advertisement expenditure
and sales revenue may be shown as:
Leverage = % Change in Sales Revenue /% Change in Advertisement

Expenditure
= 100%
20%
=5
The above calculations show that sales revenue increases 5 times the increase in the
advertisement expenses. It means there is Rs 5 increase in sales revenue because of
one rupees increase in advertisement expenses.
4. Types of Leverage Analysis:

Leverage analysis in financial management can be divided into three sections:
Figure 3: Types of Leverage Analysis
4.1. Operating Leverage:
Operating leverage measures the impact of sales revenue on the operating profits of the
firm (EBIT). It can be defined as the % change in EBIT divided by the % change in sales
revenue. Therefore, operating leverage studies the relationship between the firms sales
revenue and its earnings before interest and tax.
It can be expressed as
Operating Leverage= % Change in EBIT/ % Change in Sales
As discussed above, operating leverage shows the responsiveness of firms EBIT with
respect to a change in firms sales. Operating leverage is an indicator of the business risk
of the firm. Business risk means variability in the EBIT of the firm because of
employment of fixed operating cost. Business risk of the firm depends upon internal as
well as external factors. Internal factors may include investment decisions of the firm
and management policies while external factors include general economic conditions,
government policies, competition, technological changes and natural calamities. These
external factors may be peculiar to a particular company or may be common to all the
companies. Normally, business risk is unavoidable.
Operating leverage will occur only when firm is incurring fixed operating expenses.
Therefore, existence of fixed operating cost in the overall cost structure of the firm will
have magnifying effect of percentage increase in sales over EBIT. Higher operating cost
results in higher business risk therefore higher operating leverage. Thus, operating
leverage is an index of business risk of the firm. If there is no fixed operating cost then
operating leverage will not exist. Thus, no business risk to the firm.
Illustration 1:
A company sells 2000 units @ 10 Rs per unit. The variable cost of production is Rs. 5 per
unit. Calculate Operating Levearge.
Solution 1:
The operating profits (EBIT) of the firm will be (10-5)*2000 = Rs 10,000. Suppose if the
sales of the firm increased by 50%.
Then, new equation will be
Sales 3000 units @ Rs 10 per unit.
So, profit will be (10-5)* 3000= Rs. 15000
Operating Leverage can be obtained as
= % Change in EBIT
---------------------------------------
% Change in Sales
= Change in EBIT/EBIT
----------------------------------------
Change in Sales/Sales
= 50%/50%
= 1
So operating leverage is 1, which denotes that there is no magnifying effect of increase

in sales over EBIT. Thus, in the absence of fixed operating cost in the cost structure of
the firm any increase or decrease in the sales will have no magnifying effect over EBIT.
Therefore, one can say that operating leverage does not exist in present case.
Continuing with the same example,

If we take fixed element of cost as Rs. 1000.
Then EBIT before and after will be
Situation A Situation B
Sales@ 10/unit 20000 30000
-VC@ 5/unit 10000 15000
Fixed Cost 1000 1000
---------- ---------
9000 14000
--------- ----------
= % Change in EBIT/ % Change in Sales
= 55.55%/50%
= 1.11
In the present case, operating leverage is 1.11 which shows that 1% increase in sales
will result in 1.11% increase in EBIT. Therefore, one can say that because of existence of
fixed operating cost, operating leverage exists.
Higher operating cost results in higher operating leverage. Though higher operating
leverage may not be good but every firm must have some element of fixed operating
cost in order to have magnifying effect of sales on EBIT. Whenever % change in EBIT is
greater than % change in sales, the operating leverage exists and relationship is called
Degree of operating leverage (DOL). If DOL is more than 1, there is Operating Leverage.
DOL can also be measured for a particular sales level with the help of following formula:
DOL = Contribution/EBIT or Sales-VC/EBIT
The DOL for two different sales levels will be different. The behaviour of operating
leverage will depend upon the position of sales vis-a-vis break even sales of the firm. If
the present level of sales is more than breakeven level of sales the DOL will decrease
with every increase in sales level and vice versa. This is because, increase in fixed cost is
relatively smaller then increase in sales level. The DOL is undefined at break even sales
level as shown below
DOL = Contribution/ EBIT
(We know EBIT is zero at Break Even Sales) so DOL will be infinitive or undefined.

Figure 4: Operating Leverage and EBIT
Concluding Points of DOL
a. OL is the % change in EBIT because of % change in sales. It measures the

magnifying effect of change in EBIT because of change in sales, which results
because of fixed operating cost.
b. If there is no fixed operating cost, then there will be no operating leverage or degree
of operating leverage will be one.
c. A positive operating leverage means firm is operating at a higher level than break-
even point.
d. A negative operating leverage means firm is operating at lower level than break-even
point and firms EBIT will be negative.
Importance of Operating Leverage:
The study of operating leverage helps the finance manager in
a. To show impact of changes in sales on the level of operating profits (EBIT) of the firm
b. In case of higher DOL, a firm can earn huge profits by increasing sales volume. Firm
will incur losses if there is substantial decrease in sales volume. Therefore firm
should avoid operating under high DOL.
c. Higher DOL represents higher operating risk thereby increasing overall risk of the
firm. The study of DOL helps manager to take calculated risk.

INTERACTIVE 4
4.2. Financial Leverage:
Financial leverage represents the relationship between EPS and EBIT. Financial leverage
measure the % change in EPS because of % change in EBIT. Therefore, financial
leverage measures the responsiveness of EPS because of change in EBIT.
According to Hampton, Financial leverage exists whenever firm has debt or other
sources of fund carrying fixed charge in its capital structure
The use of cheaper source of finance debt, although results in financial leverage or
trading on equity which helps in maximising the earning per share to the equity
shareholders, will also increase the financial risk of the firm. Financial risk occurs
because of inability of the firm to pay its fixed financial costs. If firm is not earning
enough to pay interest or their fixed payments the financial risk as well as overall risk of
the firm will increase, So, finance manager should consider the level of debt in the
capital structure while taking financial decisions. If the firm is financed through equity
capital, then there will be no financial risk. But firm will be losing benefit of tax
deductibility of debt finance. So, higher the debt proportion in the capital structure,
higher the payment of interest, resulting in higher financial risk. Thus, financial leverage
is an indicator of financial risk of the company.
It means financial leverage occurs because of existence of fixed financial cost of the firm
in their capital structure. It can be calculated as
FL= % Change in EPS/% Change in EBIT
Whenever % change in EPS is greater than % change in EBIT, the financial leverage
exists and relationship is called Degree of financial leverage (DFL). If DFL is more than 1,
there is financial Leverage.
DFL can also be measured for a particular sales level with the help of following formula
DFL = EBIT/EBT
or = EBIT/EBT-PD/(1-T)
( In case firm is using Preference Share Capital)
Illustration 2:
If a firm is having EBIT of Rs. 10000 and it pays interest on loan of Rs.2000 (fixed
financial charge). The total number of equity share of the firm is 1000 shares. Assume
EBIT of the firm increases by Rs. 5000 and rate of income tax is 40%. Calculate
financial leverage.
Solution 2:

The financial leverage of the firm can be calculated as
% Change in EBIT= Change in EBIT/ EBIT
=5000/10000*100= 50%
% Change in EPS= Change in EPS/ EPS
EPS =(EBIT-I)(1-t)-PD/ No of Equity Shares
Where t= tax rate
PD= Preference dividend
EBIT= Earnings before Interest and Tax
Now EPS will be (before increase)
= (10000-2000)(1-.4)/ 1000
= Rs 4.8/Equity Share
EPS (after increase in EBIT)
= (15000-2000)(1-.4)/1000
= 7.8/share
Now % Change in EPS is
= 3/ 4.8*100
= 62.5%
Financial Leverage
= 62.5%/50%
= 1.25
In above example, percentage change in EBIT is 50% whereas percentage change in EPS
is 62.5%. Thus, financial leverage is 1.25 which denotes that EPS will change by 1.25
times the change in EBIT. If the firm is using cheaper source of finance i.e. debt in its
capital structure then, any given increase in EBIT will result in more than proportionate
increase in the EPS.
Figure 5: Financial Leverage

Financial leverage may be favourable or unfavourable. If firms EBIT level is higher than
the fixed financial charge then financial leverage will be positive and termed as
favourable financial leverage. If the firms EBIT level is less than fixed financial charge
then financial leverage will be negative. Negative financial leverage will result in losses
to firm and substantial decrease in EPS. But if the firm is operating at EBIT level of Rs.
2000.( i.e. just equal to recover fixed financial charge) then entire EBIT will be used for
the payment of interest and no profit will be available for equity shareholders. This is
known as financial breakeven point. Financial leverage will be undefined at financial
breakeven point as shown below
Financial Leverage= EBIT/EBT
= 2000/ Nil
= Undefined
INTERACTIVE 2
Importance of Financial Leverage:
Figure 6: Factors affecting Financial Leverage

Financial leverage helps in taking financial decisions of the firm. Financial leverage
depends on two important factors viz. rate of return and cost of debt. If return on
investment(ROI) of the firm is more than cost of debt capital then FL will be favourable
and finance manager can use more debt capital to increase the earning available to
equity shareholders. If the FL is unfavourable i.e. cost of debt is more than return on
investment then it is not advisable to use debt in its capital structure. Although it can be
argued that if firms ROI is more than cost of debt, then firm can use more and more
debt capital. Higher debt content will increase financial risk which may lead to insecurity
of equity shareholder. Therefore, an optimum mix of debt and equity in capital structure
will result in wealth maximisation of equity share capital.
INTERACTIVE 3
4.3. Combined Leverage:
Figure 7: Types of Leverages and Risks

As discussed in previous pages, Operating Leverage determines the operating risk of the
firm and financial leverage determines the financial risk of the firm, but finance manager
or investor is concerned with the overall risk of the firm. Combined leverage helps in
ascertaining overall risk of the firm. Combined leverage can be defined as percentage
change in EPS for a given percentage change in Sales. Combined leverage can also be
obtained by product of financial leverage and operating leverage as shown below:
CL= OL*FL
Or CL= % Change in EBIT/ % Change in Sales * % Change in EPS/ % Change

in EBIT
Or % Change in EPS/ % Change in Sales
Degree of Combined Leverage (DCL) can be calculated as
DCL= DOL*DFL
Value Addition 3: Know More

Relationship between Leverage and Business Risk
Click on the link below to gain an insight into the relationship between Leverage and
Business Risk.
Source: http://www.yourarticlelibrary.com/business/relationship-between-leverage-and-
business-risk/44217/
INTERACTIVE 1
Combined leverage takes into account both fixed operating and fixed financial cost.
Combined leverage helps in studying the behaviour of EPS because of a change in sales
revenue. A finance manager can measure the impact of an increase or decrease in sales
over earning per share. As given above, combined leverage helps the finance manager
calculate the overall risk of the firm. If the manager wants to take high financial risk
then he has to reduce its operating risk so that overall risk of the firm does not go
beyond limits. On the basis of above arguments a firm can be categorised into 3
categories:
Figure 8: Leverages and Types of Firms
Risky Firms: Those firms which are running under high financial and operating leverage
are called risky firms. The combined leverage is also high in this case.
Normal Firms: A firm having either high financial leverage and low operating leverage
or high operating leverage and low financial leverage. The combined leverage is normal
in this case.
Ideal Firms: The firms which have both financial and operating leverage at the lowest
point.
INTERACTIVE 6
Value Addition 4: Quiz

Multiple Choice Questions
Click on the link below to take a quiz on Operating and Financial Leverage
Source: http://web.utk.edu/~jwachowi/tfquiz/tf16.html
5. EBIT-EPS Analysis:
EBIT-EPS analysis is a very strong and important tool in the hands of the finance
manager. This is an alternative technique to measure the impact of financial leverage on

the returns available to equity shareholders. Under EBIT-EPS analysis, an attempt is
made to analyse the impact of change in the capital structure on earnings available to
equity shareholders. Thus, EBIT-EPS analysis shows the relationship between EBIT and
EPS at various financing pattern i.e. debt equity ratio. The financing mix, which yields
the maximum EPS to equity shareholders under assumed EBIT level, is regarded as the
best mix or the optimum capital structure.
There are two ways to analyse the relationship of EBIT and EPS. These two ways are:
Figure 9: Relationship between EBIT and EPS
(1) Constant EBIT with Changing Financing Pattern

(2) Varying EBIT with Changing Financing Pattern
Constant EBIT with Changing Financing Pattern:
In this section, we will try to analyse the impact of various financing patterns on the
return available to equity shareholders assuming constant level of EBIT. The return
available to equity shareholders is the residue part of the profit. The total operating
profit is divided into various claimants. These are four claimants of EBIT as shown
below:
Figure 10: Claimants of EBIT

After payment to the first three claimants, the remaining portion is distributed as equity
dividend by dividing the amount available to equity shareholders by the total number of
equity shares. The statement of calculation of EPS can be prepared as follows:
Particulars Amount (Rs.)
EBIT XXX
Less: Interest XXX
-----------------
EBT XXX
Less: Tax XXX
-------------------
EAT XXX
Less: Preference Dividend XXX
---------------
Earnings Available to Equity Shareholders XXX
Number of Equity Shares XXX
EPS (Earnings to ESH/ No of Equity Shares) XXX

The EPS will be different for different financing patterns assuming constant level of EBIT.
It is because the interest paid is tax deductible which resulted in tax benefits to equity
share holders. Thus, interest on debt capital can be used to increase the return to equity
shareholders.
However it should be remembered that interest is a liability i.e. fixed financial charge on
the earning of the company. It increases the risk perception of the investor. So, its not
possible to keep increasing the level of debt content in the capital structure of the
company. The ratio of debt in capital structure will depend on various factors like nature
of business, market conditions, economic conditions, earning pattern of the company
and cost of the debt. But the two important factors which determine the level of debt
content in the capital structure are rate of interest on debt capital and rate of return on
overall capital. If the rate of interest is higher than the rate of return to the firm, it is
better to use less amount of debt content in the capital structure. In such a case, equity
shareholders will bear a part of cost of debt and EPS will decline.
Similarly, when rate of return on capital exceeds rate of interest on debt, higher amount
of debt can be used in the capital structure which will result in disproportionate increase
in the earnings available to equity shareholders (ESH) and EPS will increase.
Illustration 3:
A company is expecting EBIT of Rs. 5,00,000 per annum on investment of Rs.

10,00,000. Company is in need of Rs. 8,00,000 for its expansion activities. Company can
raise this amount by either equity shares capital or 12% preference share capital or 10%
debentures. The company is considering the following financing patterns:
a. 10,00,000 through issue of Equity Shares at par;

b. 5,00,000 by issue of Equity Share Capital and remaining 5,00,000 by issue of
Debentures;
c. 5,00,000 through Equity Shares and 2,50,000 through 12% Preference Share Capital
and remaining 2,50,000 through 10% Debentures.;
d. 5,00,000 through Debt and 2,50,000 through Equity Shares and remaining 2,50,000
through 12% Preference Share Capital.
Find out the best financing mix assuming 50% tax rate.
Solution 3:
Capital Structure Plan I Plan II Plan III Plan IV
Equity Share of 100

each 10,00,000 5,00,000 5,00,000 2,50,000
12% Preference Share ----- ----- 2,50,000 2,50,000
10% Debt ------ 5,00,000 2,50,000 5,00,000
Total Capital Employed 10,00,000 10,00,000 10,00,000 10,00,000
Particulars Plan I Plan II Plan III Plan IV

EBIT (ROI 25%) 5,00,000 5,00,000 5,00,000 5,00,000
Less: Interest -------- 50,000 25,000 50,000
________________________________________________
EBT 5,00,000 4,50,000 4,75,000 4,50,000
Less: Tax (50%) 2,50,000 2,25,000 2,37,500 2,25,000
_______________________________________________
EAT 2,50,000 2,25,000 2,37,500 2,25,000
Less: Preference Dividend --------- ---------- 50,000 30,000
Earnings to Equity
Shareholder 2,50,000 2,25,000 1,87,500 1,95,000
Number of shares 10,000 5,000 5,000 2,500
EPS(Rs.) 25 45 41.5 78
In the above example, alternative IV seems to be best alternative with EPS of Rs. 78.
The EPS is Rs. 25 when no debt is used in the capital structure. The EBIT of Rs. 5,00,000
on investment of RS 10,00,000 turn out to be 50%. After tax ROI will be 25%. But the
use of cheaper source of finance such as debt at 10% cost and preference share at 12%
cost will increase earnings per share. Thus, use of more and more debt or fixed payment
capital will lead to increase in EPS to the shareholders.
Thus, we can conclude the followings:
a. Financial leverage (use of debt) has a favourable impact on the EPS only when ROI is
more than cost of debt (net of tax).
b. The EPS keeps increasing with the use of debt content in the capital structure till ROI
is more than cost of debt.
c. Financial leverage will have unfavourable impact on EPS if ROI is less than cost of
debt at any point of time.
Varying EBIT with Different Financing Patterns:
In the previous section, we got an insight into the impact of financing pattern on
constant EBIT levels. But in reality, it is impossible to have constant EBIT in all economic
conditions. Therefore, varying levels of EBIT will be more practical approach to consider
and analyse the impact of different financing patterns. The following example will
explain:
Illustration 4:
A company having equity share capital of Rs. 4,00,000 divided into shares of Rs. 100
each. The company wants to raise additional fund of Rs. 2,00,000 for its diversification
programme. The company has following alternatives for raising the fund:

Plan I: Issue of 20,000 Equity Shares of 100 each
Plan II: Issue of 20,000 Preference Shares of 100 each
Plan III: Issue of 10% Debentures of Rs. 100 each
The expected current EBIT level of the company in present scenario is Rs. 1,00,000. The
EBIT will change according to general economic conditions as given below:
Good Conditions: EBIT Rs. 1,20,000
Bad Conditions: EBIT Rs. 80,000
Calculate EPS in all the cases and analyse the results.
Assume tax rate of 50%.
Solution 4:
Capital Structure of the Company
Particulars Present CS Proposed Capital Structure
Plan I Plan II Plan III
Equity Shares 4,00,000 6,00,000 4,00,000 5,00,000
12% PSC ------ ----------- 2,00,000 ---------
10% Debntrure ------ ----------- --------- 2,00,000
Total Capital 4,00,000 6,00,000 6,00,000 6,00,000
Case A: When EBIT is Rs. 1,00,000 (Present Scenario)
EBIT 1,00,000 1,00,000 1,00,000 1,00,000
Less: Interest -------- ------ --------- 20,000
EBT 1,00,000 1,00,000 1,00,000 80,000
Less: Tax 50,000 50,000 50,000 40,000
EAT 50,000 50,000 50,000 40,000
Less:
Pref. Dividend -------- -------- 24,000 ----------
Earnings to ESH 50,000 50,000 26,000 40,000
Number of Shares 4,000 6,000 4,000 4,000

EPS 12.5 8.33 6.5 10
Case B: When EBIT is Rs. 1,20,000 (Good Conditions)
EBIT 1,00,000 1,20,000 1,20,000 1,20,000
Less: Interest -------- ------ --------- 20,000
EBT 1,00,000 1,20,000 1,20,000 1,00,000
Less: Tax 50,000 60,000 60,000 50,000
EAT 50,000 60,000 60,000 50,000
Less:
Pref. Dividend ---------- ---------- 24,000 --------
Earnings to ESH 50,000 60,000 36,000 50,000
Number of Shares 4,000 6,000 4,000 4,000
EPS 12.5 10 9 12.5
Case B: When EBIT is Rs. 80,000 (Bad Conditions)
EBIT 1,00,000 80,000 80,000 80,000
Less: Interest -------- ------ ------- 20,000
EBT 1,00,000 80,000 80,000 60,000
Less: Tax 50,000 40,000 40,000 30,000
EAT 50,000 40,000 40,000 30,000
Less:
Preference Dividend---------- ---------- 24,000 ----------

Earnings to ESH 50,000 40,000 16,000 30,000
Number of Shares 4,000 6,000 4,000 4,000
EPS 12.5 6.67 4 7.5
The above results can be summarized as follows:
Capital Structure Present Proposed
EPS : When
Case A:
When EBIT is 1,00,000 12.5 8.33 6.5 10
Case B:
When EBIT is 1,20,000 12.5 10 9 12.5
Case C:
When EBIT is 80,000 12.5 6.67 4 7.5
Plan I: It can be seen from the table above that in alternative plan I the percentage
increase or decrease in EPS is same as percentage increase or decrease in EBIT. For
instance, When EBIT increases form 1,00,000 to Rs. 1,20,000 i.e. 20% increase, EPS
also increase in the same ratio from Rs. 8.33 to Rs. 10 i.e. 20% increase. Similarly,
when EBIT decrease from 100,000 to Rs. 80,000 ie. 20% decline, EPS also decline by
the same percentage from Rs. 8.33 to Rs. 6.67 i.e. 20% decline.
Plan II: Similarly in alternative plan II, the increase in EPS is 38.46% as compare to the
increase of 20% in the EBIT level. The magnifying effect of cheap source of fund i.e.
preference share capital resulted in more than proportionate increase in EPS.
Plan III: In alternative plan III, the percentage increase in EPS is 25% while EBIT
increases from 1,00,000 to 1,20,000. Thus percentage increase in EPS is more than the
percentage increase in EBIT. It is because of leverage or using cheaper source of finance
i.e. debt in the capital structure of the company. The after tax cost of debt is 5% (10%
(1-t)). Thus the use of cheaper source of finance leads to magnifying effect on the
earnings available to equity shareholders.
Thus from the above discussions, we conclude:
a. When there is fixed financial charge or debt content in the capital structure of the
firm, the percentage change in the EPS is equal to percentage change in EBIT as
seen in the alternative Plan I.

b. Use of fixed payment capital like preference shares and debentures results in
magnifying effect on the EPS. It means us e of cheap source of finance will lead to
more than proportionate increase in the EPS as seen in the alternative (b) and (c)
both.
c. Us e of leverage (debt and preference shares) in the capital structure will have
unfavorable impact on the EPS if return on investment is less than cost of debt.
Financial Break -Even Level:
The EBIT level at which, firm is able to cover its fixed financial charge (interest and
preference dividend) is called financial break -even level. The earnings available to
equity shareholders will be zero at financial break -even level. Thus financial break- even
level means that level of EBIT which lead to zero EPS. The EPS will be positive above the
financial break- even level of EBIT while EPS will go down if EBIT falls below the break -
even level.
Financial break-even level can be obtained as follows:
(i) When debt and preference shares are used in capital structure
EBIT= Interest +PD
(1-t)
Where I= interest payment
PD= preference dividend (preference dividend will be adjusted for corporate
dividend tax if information is given)
T= rate of income tax
(ii) When only debt is used in the capital structure

EBIT= Interest
Illustration 5:
A firm has 5,00,000, 10% debentures in their capital structure . The company also pay
preference dividend of RS. 50,000. The income tax rate is 40%. Company also pays
corporate dividend tax @20%.
Find out financial break-even level of EBIT.
Solution 5:
Financial break-even level when dent and preference shares are used
EBIT = I+ PD(including (CDT)/(1-t)
= 50,000 + 60,000(50,000+10,000)/ (1-.4)
= 50,000+ 60,000/.6
= 1,50,000Rs.

Verification:
EBIT 1,50,000
Less: Interest 50,000
--------------------------
EBT 1,00,000
Less: Tax (40%) 40,000
----------------------------
EAT 60,000
Less:
PD (Including CDT) 60,000
___________________
EPS NIL
___________________
Indifference Level of EBIT:
Indifference level of EBIT is that level of EBIT where two or more different capital
structure leads to same EPS. It means an attempt is made to find out EBIT which will
result in equal earning per share for two different financing patterns. Calculation of
indifference level of EBIT plays an important role in capital designing decisions. If
expected EBIT is more than the indifference level of EBIT, a firm can go for higher debt
content in the capital structure as it will lead to increase in the earning per share of the
firm. But if expected EBIT is less than indifference level of EBIT, any increase of debt
content will lead to decrease in the EPS for shareholders. Thus in later case it is
advisable to use more of equity than the debt in capital structure. In this analysis EBIT is
taken as dependent variable while EPS is taken as independent variable. Thus students
are required to ascertain the indifference level of EBIT in different financing patterns.
Calculation of indifference level of EBIT require two steps
STEP 1: Calculate EPS in equation form for different financing pattern assuming EBIT as
X
STEP 2: Compare two financing pattern to calculate EBIT
Following are possible financing pattern available to the firm.
a. When only equity shares are used for financing

EPS = EBIT (1-t) (Equation 1)
N1
Where N1 = Number of Shares

b. When debt and equity are used for financing:
EPS = (EBIT- I)(1-t)
N2 (Equation 2)
Where N1= Number of Shares (N2 will be different than N1 because of

different equity capital in these two different financing pattern)
c. When debt, equity and preference shares are used for financing:
EPS = (EBIT-I)(1-t)- PD
N3 (Equation 3)
Where PD= Preference Dividend
N3= Number of Shares
d. When equity and preference share capital is used for financing:

EPS = EBIT (1-t)- PD
N4 (Equation 4)
Where N4= Number of Shares
Note: N1, N2, N3, N4 will depend upon the amount of equity capital used in particular
financing mix.
Illustration 6:
A company is considering a capital structure of RS. 10,00,000 for which following options
are available. Calculate indifference level of EBIT in each case;
a. Equity share capital of RS. 10,00,000 or 10% debentures of RS. 5,00,000 and
remaining amount from equity share capital.
b. Equity share capital of Rs. 8,00,000 plus 10% debentures of Rs. 200,000 Or equity
share capital of Rs. 7,00,000 plus 12% preference share of Rs. 3,00,000.
c. Equity share capital of Rs. 10,00,000 Or equity share capital of Rs. 5,00,000 plus
10% debenture of Rs. 2,50,000 plus 12% preference share of Rs. 2,50,000.
Solution 6:
Calculation of Indifference Level of EBIT
a. The this case all equity financing is compared with debt and equity financing ,
therefore equation number 1 and 2 will be compared to find out indifference level of
EBIT
All Equity = Equity + Debt

EBIT (1-t) = (EBIT- I)(1-t)
N1 N2
EBIT (1-.5)
10,000 = (EBIT-50,000)(1-.5)
5,000
On solving, we get
EBIT= Rs. 1,00,000.
Thus, indifference level of EBIT is RS. 1,00,000.

Verification:
Particulars Plan I Plan II
All Equity Debt + Equity

EBIT 1,00,000 1,00,000
Less: Interest - 50,000
------------------------------------------------
EBT 1,00,000 50,000
Less: Tax(40%) 50,000 25,000
------------------------------------------------
EAT 50,000 25,000
Less: Preference dividend - -
-------------------------------------------------
Earnings available to Equity Shareholders 50,000 25,000
--------------------------------------------------
Number of Equity Shares 10,000 5,000
EPS Rs. 5 Rs.5
Thus at Rs. 100,000 EBIT, both financing plan will lead to equal EPS.
b. In this case, equity and debenture financing is compared with equity and preference
share capital. Thus equation no 2 and 4 will be compared to find out indifference level of
EBIT.
(EBIT-I) (1-t) = EBIT(1-t) PD
N2 N4
EBIT (1-.5)/ 10,000 = EBIT (1-.5)- 60,000/ 5,000
On solving, we get
EBIT= Rs. 3,24,000

(Verification may be done as given above)
c. This case, all equity financing is compared with equity, debt and preference share
capital. Thus equation no 1 and 3 will be compare to find out indifference level of EBIT.
EBIT(1-t) = (EBIT-I)(1-t)- PD
N1 N3
EBIT(1-.5) = (EBIT-25,000)(1-.5)- 30,000

10,000 5,000
On solving, we get
EBIT = Rs. 1,70,000
(Verification may be done)
INTERACTIVE 5
7. Review Illustrations:
1.
A firm has a sale of Rs. 90 lakh, variable cost of 20 lakh, fixed cost of Rs. 5,00,000. The
capital structure of the firm includes 10% debenture of Rs. 20 lakh and equity share
capital of Rs. 40 lakh. Calculate operating, financing and combined leverage.
Solution 1:
Statement of EBT
Sales 90 lakh
Less: Variable Cost 20 lakh
-------------------------
Contribution 70 lakh
Less: fixed Costs 5 lakh

-----------------------------
EBIT 65 lakh
Less: Interest on Debenture 2 lakh

-----------------------------
EBT 63 lakh
-----------------------------
(i) Operating Leverage = Contribution/ EBIT

= 70 lakh/65 lakh
= 1.07 times

(ii) Financial Leverage = EBIT /EBT
= 65 lakh/ 63 lakh
= 1.03 times
(iii) Combined Leverage = FLOL

= 1.07 1.03
= 1.10 times
2.
Following information is given;
EBIT = RS. 10 lakh
Preference Dividend = Rs.40,000
Operating Fixed Costs = Rs. 20 lakh
EBT = Rs.2 lakh
Tax Rate = 50%
Calculate the degree of operating, financing and combined leverage. By what percentage
the operating profits would increase if the sales increase by 10%?
Solution 2:
Calculation of leverages

= Fixed operating costs+ EBIT / EBIT
= 20lakh+ 10 lakh /10 lakh
= 3 times
(ii) Financial Leverage = EBIT

----------------------
EBT PD/(1-t)
= 10,00,00o
--------------------------------------
2,00,000 40,000/(1.5)
= 10,00,000/ 1,20,000
= 8.33 times

(iii) Combined Leverage = FL OL
= 8.33 3
=25 times.
Percentage increase in Profit if Sales increases by 10%
DOL = % increase in EBIT/ % increase in sales

3 = % increase in EBIT / 10%
% increase in EBIT = 30 %
3.
The Balance Sheet of a company is as follows:
Liability Side
Equity Share Capital RS. 60,000
Retained Earnings Rs. 10,000
10% Long Term Debt Rs. 100,000
Current Liabilities Rs.30,000
Total 2,00,000
Asset Side
Fixed Asset Rs. 160,000
Current Asset Rs. 40,000
Total Rs.2,00,000
The companys total asset turnover ratio is 3. Its fixed operating costs are Rs. 120,000
and its variable operating costs ratio is 50%. The income tax rate is 50%. Calculate all
leverages for the company given that the face value of the equity share is Rs.10. Also
calculate EPS.
Solution 3:
Total Asset Turnover Ratio = Sales/ Total Asset

3 = Sales /2,00,000
Hence, Sales = 6,00,000 RS.
Statement of Earnings
Sales 6,00,000
Less: Variable Cost 3,00,000
-------------------------
Contribution 3,00,000
Less: Fixed Operating Costs 1,20,000

-----------------------------
EBIT 1,80,000
Less: Interest on Debenture 10,000

-----------------------------
EBT 1,70,000
Less: Income Tax 85,000
-----------------------------
EAT 85,000
Less: Preference Dividend NIL
-----------------------------
Earnings available to Equity Shareholders 85,000
----------------------------
EPS = Earnings Available to Equity Shareholders / Number of Equity Shares

= 85,000 / 6000
= 14.16 Rs per share.

= 3, 00,000/ 1, 80,000
= 1.67 times

= 1, 80,000/ 1, 70,000
= 1.05 times

= 1.05 1.67
= 0.62 times

4.
The following information are given for a company
EBIT Rs. 10, 00,000
EBT Rs. 3, 20,000
Fixed Costs Rs. 5, 00,000
Calculate the % change in EPS if the sales are expected to increase by 5%.
Solution 4:
Calculation of Leverage

= 10, 00,000 + 5, 00,000/ 10, 00,000
= 1.5 times

= 10, 00,000/ 3, 20,000
= 3.125 times

= 3.125 1.5
= 4.68 times
% Change in EPS
DCL = % change in EPS/ % change in Sales

4.68 = % change in EPS/ 5%
% change in EPS = 23.43 %
5.
The following data are available for ABC Ltd.
Sales Rs.5, 00,000
Variable Cost Rs 2, 00,000
Fixed Costs Rs.1, 50, 0000
Interest Rs. 25,000
EBT Rs. 1, 25,000
a. Using the concept of leverage calculate by what percentage will EBIT increase if there
is 10% increase in sales.
b. Using the concept of leverage calculate by what percentage EPS increase if EBIT
increases by 6%
c. Using the concept of leverage calculate by what percentage will the EPS increase if
the sales increases by 8%.
Also, verify the results. Assume number of outstanding shares is 5,000 shares.
Solution 5:
Statement of EBT or Earnings
Sales 5, 00,000
Less: Variable Cost 2, 00,000
-------------------------
Contribution 3, 00,000
Less: Fixed Costs 1, 50,000

-----------------------------
EBIT 1, 50,000

-----------------------------
EBT 1, 25,000
-----------------------------
EPS = EBT/ Number of shares

= 1,25,000/ 5000 = Rs.25/share
Calculation of Leverages

= 3, 00,000/ 1,50,000
= 2 times

= 1, 50,000/ 1, 25,000
= 1.2 times
(ii) Combined Leverage = OLFL

= 2 1.2
= 2.4 times

(a) As we know that operating leverages explain the relationship between sales and
EBIT so using operating leverage
OL = % Change in EBIT /% Change in Sales
2 = % change in EBIT / 10%
So % change in EBIT is 20%
Verification of Results
Statement of New EBT
Sales 5, 50,000
Less: Variable Cost(2 lakh/5 lakh 5.5 lakh) 2, 20,000
-------------------------

-----------------------------
EBIT 1, 80,000

-----------------------------
EBT 1, 55,000
-----------------------------
% Change in EBIT = New EBIT- Old EBIT / Old or Base EBIT
= 180,000 1, 50,000 / 1, 50,000
= 20%
(b) Using the financial leverage we can calculate % change in EPS
FL = % change in EPS/% change in EBIT
1.2 = % change in EPS / 6%
Hence % increase in EPS is 7.2%
Verification:
Statement of New Earnings
EBIT (6% more than previous) 1, 59,000

-----------------------------
EBT 1, 34,000
-----------------------------
New EPS = EBT/ Number of Shares

= 1, 34,000 / 5,000
= Rs. 26.8
% Change in EPS = New EPS Old EPS / Old EPS

= 26.8 25 / 25
= 7.2%
(c) Using combined leverage, we can calculate % change in EPS
CL = % Change in EPS / % Change in Sales

2.4= % Change in EPS / 8%
Hence, % increase in EPS will be 19.2%
Verification:
Statement of New EBT or Earnings
Sales (8% more) 5, 40,000

Less: Variable Cost 2, 16,000
-------------------------

-----------------------------
EBIT 1, 74,000

-----------------------------
EBT 1, 49,000
-----------------------------
New EPS = EBT/ Number of Shares

= 1, 49,000/ 5000 = Rs.29.8/share
% Change in EPS = New EPS Old EPS / Old EPS

= 29.8 25 / 25
= 19.2%

Value Addition 5: Quiz
Multiple Choice Questions
Click on the link below to take a quiz on financial and operating leverage.
Source: http://web.utk.edu/~jwachowi/mcquiz/mc16.html
Summary:
Leverage can be explained as the relationship between two interrelated variables.
Leverage can be of three types viz financial, operating and combines.
Operating leverage measure the operating risk of the firm while financial leverages
measure financial risk.
Operating g leverage occurs because of fixed operating expensed of the firm.
Financial leverage occurs because of use of fixed financial costs like interest on debt.
Study of leverage helps in capital structure decisions and in controlling overall risk
also.
Leverage analysis helps in studying the relationship among three important variable
like sales , EBIT, and EBT
Glossary:
Trading on Equity: Use of debt in capital structure to produce gain to the residual
owners i.e. equity shareholders.
Break Even Sales: It is the sales level where there is no profit and no loss to the
company. Thus break even sales is the minimum amount of sales needed for making
a profit. If total sales are more than break even sales, it will result into profit.
Operating Risk (Business Risk): Basel II defines operating risk as risk of loss
resulting from inadequate or failed internal processes, people and systems or from
external events. Thus business risk occurs because of failed internal management or
market conditions which are beyond company control.
Financial Risk: Financial risk is the risk caused because of existence of fixed
financial payments like interest on debentures or loans. It occurs because of debt
content in capital structure. Higher amount of debt content in capital structure will
results in higher financial risk.
Optimum Capital Structure: It is a capital structure or range of capital structure
which results in maximum earning to equity shareholders (EPS). It results because of
best mix of debt and equity capital in the overall capital structure of the firm.
Exercises:
I. Objective Type Questions:
A. Fill in the Blanks.

1. Financial leverage occurs when firm has .in its capital structure.
2. Operating leverage is an index of ..risk.
3. DCL (Degree of Combined Leverage) = DOL (Degree of Operating Leverage)

4. Total risk of the firm consists of .risk and Financial risk.
5. Operating Leverage 1.5 denotes that percentage change in EBIT is the
percentage changes in Sales.
B. State Whether Following Statements are True or False.

1. Operating risk is associated with financial costs.
2. Operating leverage shows the relationship between EBIT and EPS
3. Operating and Financial risk occur because of same reasons.
4. Combined leverage shows the relationship between sales and EPS.
5. A High combined leverages is always beneficial for the company.
II.Theoretical Questions:
1. Define leverage. What are different types of leverages?
2. What are importance and limitations of leverage analysis?
3. Differentiate between financial leverage and operating leverage.
4. Explain the causes of financial risk and operating risk. How can these two be
measured?
5. Explain the importance of financial leverage in capital structure decisions.
III. Numerical Questions:
1. A company has a sales of Rs. 20,00,000, variable cost of Rs. 14,00,000. Fixed cost of
Rs. 4,00,000 and debt of Rs, 10,00,000 at 12% rate of interest. What are the operating
and financial and combined leverages?
2. Calculate the operating and combined leverage from the following data:
Sales 2,00,000 units at Rs. 50 per unit.
Variable Cost per unit Rs.25
Fixed Charges Rs. 25,00,000
Interest Charges Rs. 10,00,000
3. Following data of a company is given below:
Sales 90,00,000
Variable Cost 50,00,000
Fixed Costs 10,00,000
Interest Payment Rs.5,00,000
Calculate degree of operating leverage and financial leverage. By what percentage will
EBIT increase if there is 10% increase in sales? Verify the results.
4. Calculate the operating leverage and financial leverage from the following data:
EBIT Rs. 10,00,000

PAT Rs.1,00,000
Operating Fixed Cost Rs. 7,00,000
Tax Rate 40%
If the company wants to increase its PAT by 40%, what should be the percentage rise in
the sales?
5. Suri Ltd. is selling its product at R. 2 per unit. The variable cost of manufacturing has
been estimated at 75%. While the fixed cost at present sales level of Rs. 1,00,000 unit
comes to Rs. 25,000. The company has issued 10% debenture of Rs. 26,000. Find out
operating, financial and combined leverage for the firm. Also find out percentage
increase in sales if company wants to double its EPS.
Answers to Objective Type Questions:

A.
1. Debt; 2.Business ; 3.DFL; 4. Business; 5. 1.5 times/ more than.
B.
1.False; 2. False; 3.False; 4.True; 5.False.
Answers to Numerical Questions:

1. OL=3 times; FL=2.5 times; CL=7.5 times, 2. OL=2; CL=3.33;
3. DOL=1.33, DFL=1.2, % Change in EBIT=13.33%;
5. OL=2, FL=1.116,CL=2.23, % Change in Sales= 44.8%
References:
1. Work Cited and Suggested Readings:
Khan, M.Y., & Jain, P.K. (2011). Financial Management Text, Problems and Cases(Sixth
edition):TMH
Chandra, Prasanna (2008). Financial Management Theory and Practice(seventh edition): TMH
Pandey, I.M.,(2010). Financial Management, Vikas Publications
Van Horne, James C., John Wachowicz, Fundamentals of Financial Management ,Pearson
education.
Ross, Stephen A., Westerfield , Randolph and Jeffery Jaffe, Corporate Finance,TMH
Srivastava, Rajiv and Anil Mishra, Financial Management, Oxford University Press.
Singh, Preeti. Financial Management, Ane Books Pvt. Ltd.
Brealey, Richard A.,& Stewart C. Myers, Corporate Finance, Capital Investment and Valuation,
MGH
Singh, S. & Kaur, R., (2012) Basic Financial Management, Mayur Paperbacks.
2. Web Links:
Visit the URL http://www.nfib.com/article/ital-50036/ to know the best way to access
capital for the business.
Visit the URL http://www.yourarticlelibrary.com/financial-management/capital-
structure/concept-and-features-of-optimal-capital-structure/44035/ to gain an
insight into the concept of optimal capital structure.
Visit the URL http://www.yourarticlelibrary.com/financial-management/ebit-eps-
analysis-in-leverage-concept-advantages-and-other-details/44224/ to gain an insight
into the concept of EBIT-EPS Analysis and Leverage.

3. Video Links:
Visit the URL https://www.youtube.com/watch?v=RE47rGfHSTo to gain an insight into the

concept of financial leverage.
https://www.youtube.com/watch?v=vd1sPZ-k57U
https://www.youtube.com/watch?v=Y08aVIxkIgw

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Institute of Lifelong Learning, University of Delhi Page | 1

Institute of Lifelong Learning, University of Delhi Page | 2

After reading this lesson, you should be able to:

Figure 2: Components of Capital Structure

Institute of Lifelong Learning, University of Delhi Page | 3

Value Addition 1: Video

Value Addition 2: Know More

Therefore, leverage may be defined as a % change in one variable (dependent) divided

Alternatively, it can be shown as

Leverage = % Change in Dependent Variable

Institute of Lifelong Learning, University of Delhi Page | 4

Leverage = % Change in Sales Revenue /% Change in Advertisement

4. Types of Leverage Analysis:

Figure 3: Types of Leverage Analysis

4.1. Operating Leverage:

Operating Leverage= % Change in EBIT/ % Change in Sales

Then, new equation will be

Sales 3000 units @ Rs 10 per unit.

So, profit will be (10-5)* 3000= Rs. 15000

Operating Leverage can be obtained as

So operating leverage is 1, which denotes that there is no magnifying effect of increase

Continuing with the same example,

Then EBIT before and after will be

Sales@ 10/unit 20000 30000

-VC@ 5/unit 10000 15000

Fixed Cost 1000 1000

= % Change in EBIT/ % Change in Sales

DOL = Contribution/EBIT or Sales-VC/EBIT

DOL = Contribution/ EBIT

Institute of Lifelong Learning, University of Delhi Page | 7

Concluding Points of DOL

a. OL is the % change in EBIT because of % change in sales. It measures the

Importance of Operating Leverage:

The study of operating leverage helps the finance manager in

Institute of Lifelong Learning, University of Delhi Page | 8

4.2. Financial Leverage:

FL= % Change in EPS/% Change in EBIT

( In case firm is using Preference Share Capital)

Institute of Lifelong Learning, University of Delhi Page | 9

% Change in EBIT= Change in EBIT/ EBIT

% Change in EPS= Change in EPS/ EPS

EPS =(EBIT-I)(1-t)-PD/ No of Equity Shares

Where t= tax rate

PD= Preference dividend

EBIT= Earnings before Interest and Tax

Now EPS will be (before increase)

EPS (after increase in EBIT)

Now % Change in EPS is

Figure 5: Financial Leverage

Institute of Lifelong Learning, University of Delhi Page | 10

Financial Leverage= EBIT/EBT

Importance of Financial Leverage:

Figure 6: Factors affecting Financial Leverage

Institute of Lifelong Learning, University of Delhi Page | 11

4.3. Combined Leverage:

Figure 7: Types of Leverages and Risks

Institute of Lifelong Learning, University of Delhi Page | 12

Or CL= % Change in EBIT/ % Change in Sales * % Change in EPS/ % Change

Or % Change in EPS/ % Change in Sales

Degree of Combined Leverage (DCL) can be calculated as

Value Addition 3: Know More

Figure 8: Leverages and Types of Firms

Value Addition 4: Quiz