Pillai Institute of Management Studies and

Research (PIMSR),
New Panvel

Master of Management Studies (MMS)

1
 MMS – Semester - II
Subject : Financial Management (FM)

Chapter-9 : Analysis of Leverages

(Theory and Problems )
Lecture date : 1.4.2020

by
Dr. K.G.S. MANI

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Lecture date : 1.4.2020
Chapter - 9 : Analysis of Leverages
(1) Meaning of Leverage :
The term leverage refers to the relationship between two inter-
related variables. It represents the influence of one financial
variable over some other related financial variable. Leverage is
used to describe the firm’s ability to use fixed cost, assets or funds
to magnify the return to its owners. Thus leverage can be defined
as “relative change in profits due to a change in sales”. A
high degree of leverage means large change in profits due to a
relatively small change in sales. Thus, higher the leverage, higher
is the risk and higher is the expected return.

Leverage means change of one variable in relation to change in

other variable : (see page-5 and 6 for explanations)
Examples: (i) Sales and Operating Profit (or PBIT or EBIT)
(ii) Distributable profit and Market Price of Equity Shares,
(iii) Output of production and total cost of production.
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(2) Types of Leverage :
There are three commonly used measures of leverage in financial
analysis as follows :
(i) Operating Leverage (OL),
(ii) Financial Leverage (FL),
(iii) Combined Leverage (CL) or Composite Leverage (it means, the
combination of (i) and (ii) above).
(i) (a) Operating Leverage (OL) : The operating leverage is
defined as the employment of an asset with a fixed cost, with the
hope that sufficient revenue may be generated to cover all the
fixed and variable costs. OL is the ratio of net operating income
(Contribution or ‘C’) before fixed charges to net operating income
after fixed charges. It can be also be defined as “the tendency of
the operating profit to vary disproportionately with sales”. Thus,
operating leverage is a function of three factors, namely :
(1) Fixed amount of cost (Fixed cost),
(2) Variable contribution of margin,
(3 ) Volume of sales
4
Format for Calculation of Operating Leverage (OL) :
Description Amount (Rs)
Sales(S) : xx
(-) Variable Cost (VC): xx
Contribution (C): xx
(-) Fixed Cost (FC): xx
Operating Profit (OP): xx
(or) PBIT (or) EBIT

Operating Leverage : Formula :

Contribution C C
Operating Leverage (OL) = ------------------- = ------- (or) --------
Operating Profit EBIT PBIT
Contribution means sales minus variable cost, and operating profit
means Earnings before Interest and taxes (EBIT). EBIT and PBIT
both are the same.

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Example-1 : (Rs in lakhs)
Descriptions 100% 140%
Sales (S): 5.00 7.00
(-) Variable Cost(VC): 3.00 4.20
Contribution (C) : 2.00 2.80
(-) Fixed Cost (FC): 1.00 1.00
Operating Profit (OP): 1.00 1.80
(OP, PBIT, EBIT)

Ratio (PBIT to Sales): Formula : Operating Profit to Sales :

At 100% = (1.00/5.00) x 100 = 20%
At 140% = (1.80/7.00) x 100 = 25.71% (increases disproportionately)

(Note : If the increase is proportionate = 100% increases to 140% and

hence PBIT should increase at 40% = 20 X 140% = 28% but it is
not increasing proportionately but increases disproportionately).

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Example-2 :
Another comparison (refer example-1): (Rs in lakhs)
At 100% At 140%
OP or PBIT = 1.00 1.80
Contribution = 2.00 2.80

Ratio = PBIT / Contribution =

At 100% = (1.00 / 2.00) x 100 = 50%
At 140% = (1.80/2.80) x 100= 64.28% (increases disproportionately)

(Note : If it is proportionate increase, the ratio should be as follows :

At 100% the ratio is 50%
At 140 % the ratio should be = 50% x 140% = 70%, (compare with
64.28%. Hence PBIT does not increase proportionately). It is
because, the fixed expenses (depreciation) will be same at any
levels of production (if 10,000 units are produced or 1,00,000 units)

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(b) Operating Leverage :
Formula :
Contribution C C
Operating Leverage (OL) = ------------------- = ------- (or) --------
Operating Profit EBIT PBIT
Contribution means sales minus variable cost, and operating profit
means Earnings before Interest and taxes (EBIT). EBIT and PBIT
both are the same.
(c ) Key points of OL :
(1) Operating Leverage (OL) is a measure of Business Risk.
(2) OL is associated with Capital Budgeting Decisions (or Asset Mix
decisions).
(3) OL exists if there are fixed costs.
(4) OL shows the impact of change in sales on operating income
(i.e. EBIT).
(5) OL of 1.5 means that 1% increase in sales would result in 1.5%
increase in operating profit (EBIT).

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(d) Degree of Operating Leverage (DOL) :
The degree of operating leverage may be defined as a
percentage change in the profits resulting from a percentage
change in the sales. It can be put in the form of a formula as
follows :
Percentage change in net operating income
DOL = ----------------------------------------------------------
Percentage change in sales

Note :
If the Company (firm) has a high degree of operating leverage,
a small change in sales will have a large effect / impact on
operating income. The firm should not operate under conditions
of a high degree of operating leverage because it is a very risky
situation where a small decline in sales will affect its profits
substantially.

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Students should remember the following points :
(i) Operating Leverage explains the relationship between sales and
PBIT (EBIT or operating profit). If the sales increased by
certain percentage, Operating profit will also increase (but no
proportionately). (Refer to problem-1).
(ii) Cost statement :
Sales (S) : xx
(-) Variable cost(FC): xx
Contribution (C) : xx
(-) Fixed Cost (FC) : xx
OP (or) PBIT (or) EBIT: xx
(iii) Highly- geared company, and Low-geared company .
(iv) In the leverage, while selecting the debt instrument in the
capital structure, between debentures and bank loan,
debentures should be selected, since it is for fixed interest rate.
But bank loan is based on the floating interest rate (which
increases over a period of time).
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(v) PBIT : xx
(-) Interest : xx
PBT : xx
(-) Tax : xx
PAT : xx

(vi) PAT = PBT x (1 – tax)

PBT = PAT / (1 – tax)

(vi) EPS = (Distributable profit for equity shareholders /

No of equity shares)

(vii) Operating Profit, PBIT and EBIT all mean the same. PBT and
EBT both are same. Similarly, Distributable profit or Profit
available to equity share-holders are the same.

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Problem-1 :
Operating Leverage (OL)

An analytical statement of AB company is given below.

It is based on an output (sales) level of 80,000 units.
Items Amount (Rs)
Sales 9,60,000
Variable cost 5,60,000
Fixed cost 2,40,000
Interest 60,000
Tax 50,000
Calculate Operating Leverage
and write comments.

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Solution-1 : (Operating Leverage) (OL)
(Format for calculation of Operating Profit: (see page No.5)

Description Amount (Rs)

Sales (S): 9,60,000
(-)Variable Cost (VC): 5,60,000
Contribution (C): 4,00,000
(-) Fixed Cost: 2,40,000
Operating Profit (OP): 1,60,000
(or PBIT or EBIT)

Formula :
Operating Leverage (OL) = (Contribution /PBIT) = C/PBIT =
= 4,00,000 / 1,60,000 = 2.5 times
(Note : Students are advised to following table method (this method).

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Solution – 1 :
(another method)

Operating Leverage (OL) =

Contribution / Operating profit (or) EBIT
(or) PBIT

Sales (S) = 9,60,000

Variable Cost (V) = 5,60,000
Contribution (C) = S – V
Contribution = 9,60,000 (-) 5,60,000 = 4,00,000
EBIT = contribution (-) fixed cost
EBIT = 4,00,000 (-) 2,40,000 =
1,60,000

Formula :
Operating Leverage (OL) =
= Contribution / EBIT =

OL = C / EBIT =
4,00,000 / 1,60,000 = 2.5 times

Comments : Operating Leverage is 2.5

times. In other words, contribution
generated by the company is 2.5 times of
EBIT or PBIT.

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Problem-2 :
Operating Leverage:

The installed capacity of a factory is 600 units. Actual capacity used

is 400 units. Selling price per unit is Rs 10, variable cost is Rs 6 per
unit. Fixed cost Rs 400, 1,000 1,200 respectively. Calculate
Operating Leverage (OL) in each of the following three situations.
Write comments.

Solution - 2 : Amount (Rs)

  Situation -1 Situation-2 Situation-3
(i) Sales 4,000 4,000 4,000
(ii) Variable cost 2,400 2,400 2,400
(iii) Contribution (S - V) (i) – (ii) 1,600 1,600 1,600
(iv) Fixed Cost 400 1,000 1,200
(v) Operating profit or EBIT (iii - iv) 1,200 600 400
(vi) Operating Leverage = (iii) / (v) 1600/1200 1600/600 1600/400
  1.33 2.67 4

Comments : Operating Leverage increases with every increase in the fixed

cost in the total cost structure of the company. It shows, in situation-3 that if
the sales increases by 1%, Operating profit (EBIT) would increase by 4%.

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OPERATING LEVERAGE (OL) :

Problem- 3 :

A company produces and sells 10,000 calculators

The selling price per calculator is Rs 500. Variable
cost per calculator is Rs 200 and fixed operating
cost is Rs 20,00,000. You are required to calculate:
(a) Operating leverage
(b) If sales are up by 10% what is its impact on EBIT ?

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Solution – 3 : Amunt (Rs)
Sales Revenue (10,000 x 500) 50,00,000
Less : Variable cost (10,000 x 200) 20,00,000
Contribution (Sales - VC) 30,00,000
Less : Fixed Cost 20,00,000
EBIT (Profit) (or) Operating profit 10,00,000

Formula :
(a) Operating Leverage (OL) = Contribution / EBIT
= 30,00,000 / 10,00,000 = 3 times

(b) Degree of Operating Leverage (DOL) :

DOL = Percentage change in EBIT /
Percentage of change in sales
If the sales are up by 10%
DOL = % change in EBIT /% change in
Sales
DOL =
OL = 3
3 = a / 10
a = 3 x 10 = 30%
Thus, if sales increase by 10%, EBIT will increase by
30% (but not proportionately)

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(ii) Financial Leverage (FL) :
(a) Definition: “Financial Leverage” (FL) is defined as the ability of
the company to use fixed financial charges (interest) tp increase
the effect of change in Operating Profit (OP or EBIT or PBIT) on
the company’s Earnings per share (EPS).

Financial Leverage can also be defined as “the tendency of

residual net income to vary disproportionately with operating
profit. It may also be defined as the use of funds with a fixed
cost, in order to increase earnings per share of the company”. FL
indicates the change that takes place in the taxable income as a
result of change in the operating income. FL induces the use of
funds obtained at a fixed cost (interest) in the hope of increasing
the return to equity shareholders. (same as ‘Trading on Equity’)

Financial Leverage (FL) indicates the relationship between EBIT

(or PBIT) before charging interest and EBT (PBT) after charging
interest.
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According to Gitman, “Financial Leverage is the ability of a
company (firm) to use fixed financial charges to magnify the
effects of changes in EBIT on the company’s earnings per share”
(EPS). FL is also termed as ‘Trading on Equity’ . The concept of
trading on equity states that the company uses equity capital as
well as borrowed capital, while deciding its capital structure. The
objective of trading on equity, is to provide a higher return to the
shareholders of the company by using higher amount of fixed
interest bearing instruments such as debentures, long term loans
from banks.
FL is a measure of financial risk. The percentage change in
Earnings Per Share (EPS) occurring due to a given percentage
change in Earnings Before Interest and Tax (EBIT) or PBIT is
known as the degree of financial leverage. The financial leverage
of 1.5 means that 1% increase in EBIT would result in 1.5%
increase in EPS.
To explain to students, the concept of : (i) highly geared
company, (ii) low geared company, and (iii) trading equity.

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Formulae :
(b) Financial Leverage :

Profit before Interest and Tax PBIT

(1)Financial Leverage = ------------------------------------- = ---------
Profit before tax PBT

Note : Operating Profit, PBIT, EBIT are all meaning the same

(2) Degree of Financial Leverage (DFL) :

Percentage change in taxable income Delta PBT

DFL = ------------------------------------------------- = ----------------
Percentage change in operating income Delta PBIT

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Degree of Financial Leverage (DFL) is the ratio of the percentage
change in earning before tax to the percentage increase in
operating profit i.e. EBIT.

FL also indicates the percentage change in earning per share in relation

to a percentage change in EBIT. Accordingly, the degree of
financial leverage can also be calculated as per the following
formula :

(3) DFL = Percentage change in EPS / Percentage change in EBIT

Note : There will be no financial leverage if the result of the above

equation is less than 1.

(4) EPS = Distributable profit for equity shareholders /

No. of equity shares

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(d) Example-1 : (Explanation for Financial Leverage) :
Amount (Rs) Amount(Rs)
PBIT : 1,60,000 2,50,000
(-) Interest on Debt: 60,000 80,000
PBT (or EBT) : 1,00,000 1,70,000
Tax @ 40% : 40,000 68,000
PAT (or EAT) : 60,000 1.02,000
No.of equity shares(say) 10,000 10,000
Earnings per share(EPS): (60,000/10,000) (1,02,000/10,000)
EPS: = Rs. 6 = Rs. 10.20
Increase in interest= (20,000 / 60,000) x 100 = 33.33%
Increase in PAT ={42,000/60,000) x 100 = 70 %
Comments : For an increase of interest by 20,000 (80,000 – 60,000),
there is an increase of PAT by Rs 42,000 (1,02,000 – 60,000).
Hence it is proved, the change is disproportionate (not same
percentage of increase)

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Example-2 :
Financial Leverage (assumed figures for explanation)
Total Capital Employed (TCE) : Rs 5 crores (Rs 50 million)
Equity Capital: 2 crores (Dividend = 20% i.e. Rs 20 for Rs 100 eq. sh)
Debt (Long Term Bank Loan) = Cr 3 crores (Rs 30 million) (Interest =
12% p.a.)
Additional amount = Rs 1 crore (Rs 10 mio)
For Equity Rs 1 crore : additional dividend = 1 cr. X 20% = Rs 20 lakhs
For Loan Rs 1 cr. = additional interest = 1 cr x 12% = Rs 12 lakhs
say, PBIT = Rs 50 lakhs (Rs 5 mio)
PBT = 50 – 20 = Rs 30 lakhs
PBT = 50 – 12 = Rs 38 lakhs
Explanation : By taking additional Bank Loan of Rs 1 (instead of Equity
shares), the Company gets an additional PAT of Rs 8 lakhs (38 –
30)
to the equity shareholders by way of increased dividend. Hence,
EPS also increases because distributable profit to equity
shareholders, increases by Rs 8 lakhs. 23
(c) Key Points of FL :
(1) FL is associated with capital structure decision (or capital mix
decision).
(2) Its degree differs with the use of different forms of financing.
(3) FL exists if there is use of interest-bearing funds in the capital
structure of the company.
(4) In case of high degree of FL, variability in shareholders’
earnings increases.
(5) In case of high degree of FL, probability of insolvency
increases.
(6) In case of low degree of FL, variability in shareholders’
earnings decreases.
(7) Incase of low degree of FL probability of insolvency decreases.
(8) EPS will increase if ROI (ke) is more than Cost of debt (kd).
(9) EPS will decrease if ROI (ke) is less than Cost of debt (kd).

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Financial Leverage :
Problem – 4

Z ltd has given the following details : Amount Rs

Sales 48,00,000
Variable cost 24,00,000
Fixed cost 12,00,000
It has borrowed Rs 10,00,000 at 15% p.a. and its equity
capital is Rs 10,00,000. Calculate the following :
(i) Operating leverage, (ii) Financial leverage
(ii) Write comments.

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Solution-4
Financial Leverage (FL)

Sales 48,00,000
Less : Variable cost 24,00,000
Contribution 24,00,000
Less : Fixed cost 12,00,000
PBIT 12,00,000
Less : Interest 1,50,000
PBT 10,50,000

Formula :
(i) Operating Leverage(OL) = Contribution / PBIT =
= C / PBIT
OL = 24,00,000 / 12,00,000 = 2 times

(ii) Financial Leverage (FL) =

= PBIT / PBT
FL = 12,00,000 / 10,50,000 =
1.14 times

Comments :
As compared to OL of 2 times, the FL is
less at 1.14 times.

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Problem-5 (assignment)
Financial Leverage (FL)

An analytical statement of AB company is given below.

It is based on an output (sales) level of 80,000 units.
Items Amount (Rs)
Sales 9,60,000
Variable cost 5,60,000
Fixed cost 2,40,000
Interest 60,000
Tax 50,000
Calculate Financial Leverage and Write
comments.

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Solution – 5:
Calculation of Financial Leverage (FL)

Sales 9,60,000
Less : Variable cost 5,60,000
Contribution 4,00,000
Less : Fixed Cost 2,40,000
Operating profit (EBIT or PBIT) 1,60,000
Interest 60,000
Earnings before tax (EBT or PBT) 1,00,000
Tax 50,000
Profit after tax (PAT) 50,000

Financial Leverage = EBIT / PBT (or)

PBIT / PBT (both are same)
FL = 1,60,000 / 1,00,000 = 1.6 times

Comments :
Financial Leverage (FL) indicates the
increase of PBT and EPS in relation to
certain percentage of change in Operating
Profit (PBIT).

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Problem – 6 (assignment)
Financial Leverage

Where capital structure consists of equity shares, preference shares,

and debt.
A company has the following capital structure (Amount Rs)
Equity share capital 1,00,000
20% Preference share capital 1,00,000
8% Debentures 1,25,000
Present EBIT is Rs 50,000
Company is 50% tax bracket
Calculate Financial Leverage (FL) and
Write comments.

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Solution – 6
Financial Leverage

In this case the FL is calculated after deduction from

operating profit both interest and preference dividend
on before tax basis. Amount Rs
Operating Profit (PBIT or EBIT) 50,000
Less : Interest on debentures 10,000
Less : Pref. dividend (pre-tax basis) 20,000 30,000
Profit before tax (PBT) 20,000
FL = (PBIT / PBT) = 50,000 / 20,000 = 2.5 times

Comments :

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Problem-7 (assignment)
Financial Leverage

A company has a choice of the following three financial plans. You are required
to calculate financial leverage in each case and interpret it.
(Rupees in thousands) X Ltd Y Ltd Z Ltd
Equity capital 2,000 1,000 3,000
Debt 2,000 3,000 1,000
Operating Profit (EBIT) 400 400 400
Interest @ 10% on debt in all cases and
Write comments.

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Solution - 7 : (Rs in thousands)
Financial Leverage will be computed as follows in case of each of these plans :

 (Amount in thousands) X Ltd Y Ltd Z Ltd

Operating profit (OP or EBIT) 400 400 400
Less : Interest (10% on debt) 200 300 100
Profit before tax (PBT) 200 100 300
Financial Leverage = (EBIT / PBT) 400 / 200 400 / 100 400 / 300
Financial Leverage (FL) (times) 2 4 1.33
Interpretations :
FL indicates the change that will take place in taxable income as a result of
change in the operating income. Taking FL , X Ltd as the basis, if the operating
profit decreases to Rs 200, its impact on taxable income will be as follows :

X Ltd
Operating profit (OP or EBIT) (decreases 200
from 400)
Less : Interest 200
Profit before tax (PBT) NIL

(Calculate for Y Ltd and Z ltd)

Comments :
FL in the case of plan X is 2 times. It means every 1% change in operating profit will
result in 2% change in the taxable profit. In the above case operting profit has
decreased from Rs 400 to Rs 200 (i.e. 50% decrease) as a result the taxable profit
has decreased from Rs 200 to zero (i.e. 100% decrease)

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Problem- 8 : (assignment)

When capital structure consists of Pref. shares and equity shares :

The capital structure of company consists of the following securities.
20% Preference share capital 1,00,000
Equity share capital (Rs 10 each ) 1,00,000
Amount of operating profit is Rs 60,000. The Co. is in 50% tax bracket.
(i) Calculate Financial Leverage (FL) of the company.
(ii) What would be new financial leverage if he operating profit increases
to Rs 90,000 and interpret your results.
Write comments

(Note : Debt is not given in the problem.

Hence debt is zero and interest is also zero)

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Solution – 8

Computation of present Financial Leverage

Operating Profit (OP or PBIT) 60,000
Less : Preference dividend (20%) 20,000
Profit before tax 40,000
Present Financial Leverage = PBIT / PBT = 60,000 / 40,000
Financial Leverage = 1.5 times
If PBIT increases by Rs 30,000, what will be
new FL :
Computation of new FL :
New Operating Profit (60,000 + 30,000) 90,000
Less : Preference Dividend 20,000
Profit before tax (PBT) 70,000
Present FL = 90,000 / 70,000 = 1.286 = 1.29 times

Comments:
(i) Debt is not given in the problem, hence debt is Zero. (and interest is
also zero)
(ii) PBIT increases by 50% (from 60,000 to Rs 90,000)
(iii) This has resulted in 75% increase in PBT (from Rs 40,000 to
Rs 70,000)
(iv) Comparison : Change in PBIT = (30,000/60,000) x 100 = 50%
Change in PBT = [(70,000 – 40,000) / 40,000 ] x 100 = 75%

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(iii) Combined Leverage (CL) (or) Composite Leverage :
Combined Leverage (CL) expresses the relationship between
revenue on account of sales and taxable income. It may be
defined as “the potential use of fixed costs, both operating and
financial which magnifies the effect of sales volume on the
earnings per share of a company”. Thus, degree of combined
leverage is the ratio of percentage change in earning per share
to the percentage change in sales. It indicates the effect of the
change in sales on earning per share. Operating leverage and
financial leverage are closely concerned with the firm’s capacity
to meet its fixed costs, both operating and financial. If both
the leverages are combined, the result obtained will disclose
the effect of change in sales over change in taxable profit.
Combined leverage can also be called as composite leverage.

Combined leverage is a measure of total risk. The percentage

change in EPS occurring due to a given percentage change in

35
 sales is known as the degree of combined leverage. It is the
product of degree of operating leverage and degree of financial
leverage.
Formula for Combined Leverage (CL) :

Contribution PBIT Contribution C

(1) CL = ------------------ x --------- = ---------------------- = --------
PBIT PBT PBT PBT

(2) CL = Operating Leverage (OL) x Financial Leverage (FL)

i.e. CL = OL x FL

(3) Degree of combined leverage (DCL) :

DCL = (Percentage change in EPS) / (Percentage change in Sales)

DCL indicates the effect of change in sales on the earning per share.

36
 Points to Note :
(i) Combined Leverage (CL) and Composite Leverage (CL) both
mean the same.
(ii) Combined Leverage indicates, for every increase of certain
percentage of sales, how much will increase in taxable income (in
terms percentage (see page No. 39, problem-9)
(iii) Combined Leverage (CL) indicates the effect of change in taxable
profit over a change in sales. CL shows that for every increase of
certain percentage of sales, how much the taxable income (PBT)
will increase (in terms of percentage).
(iv) Degree of Combined Leverage (DCL) indicates the effect of change
in sales on the earnings per share (EPS)
(v) Combined Leverage (CL) is the product of Operating Leverage and
Financial Leverage. That is,
CL = (C / PBIT) x (PBIT / PBT) = C / PBT
(Hence, CL can be calculated by multiplying OL and FL)
(vi) Degree of Combined Leverage (DCL) =
(% of change in EPS ) / (% of change in Sales)
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Combined Leverage (or) Composite Leverage (CL)

Problem-9
A company has a sales of Rs 1,00,000. The variable
costs are 40% of sales while the fixed operating
costs amount to Rs 30,000. The amount of interest
on long-term debt is Rs 10,000. Calculate
Combined Leverage (CL) and illustrate its impact
if sales increases by 5%. Write
comments.

38
Solution-9
Computation of Combined Leverage Amount Rs
Sales 1,00,000
Less : Variable costs (40% of sales) 40,000
Contribution (C ) 60,000
Less : Fixed operating costs 30,000
Operating Profit (PBIT or EBIT) 30,000
Less : Interest 10,000
Profit before tax (taxable income) 20,000
(PBT)

Combined Leverage (CL) =

Operating Leverage x Fin. Leverage =
(Contribution / PBIT) x (PBIT / PBT) =
Contribution / PBT =
60,000 / 20,000 = 3 times

Combined Leverage of 3 indicates that with

every increase of 1% in sales, taxable income
will increase by 3%
This concept is explained below :

39
Second method :
C PBIT
Combined Leverage (CL) = ---------- x ----------- (or) (C / PBT) =
PBIT PBT
C = 60,000, PBT = 20,000 therefore, CL = (60,000 / 20000)= 3 times

Third method :

Operating Leverage (OL) = (C / PBIT) = 60,000 / 30,000 = 2 times

Financial Leverage (FL) = (PBIT / PBT) = 30,000 / 20,000 = 1.5 times

Combined Leverage (CL) = OL x FL = 2 x 1.5 = 3 times

40
Verification :
This can be verified by the following computations
when the sales increase by 5% (Amount Rs)
Sales (increased from 1,00,000) 1,05,000
Less : Variable costs (40% of sales) 42,000
Contribution (C ) 63,000
Less : Fixed Operating costs 30,000
Operating Profit (EBIT) 33,000
Less : Interest 10,000
Profit before tax (PBT) (increased 23,000
from Rs 20,000 to 23,000 i.e. 15%)
It can be seen that on account of increase in sales
by 5% PBT increased by 15% as shown below :
Increase in percentage of profit =
(Increase in profit / Base profit) x 100
I (3,000 / 20,000) x 10 = 15%
( Revised profit = 23,000 (-)
Base profit = 20,000
= Increase in profit = 3,000)

41
Problem-10 (assignment)
Combined Leverage

Income Statement of CRL Ltd is given below as

on 31.3.2015. Calculate the following :
(i) Operating Leverage,
(ii) Financial Leverage,
(iii) Combined Leverage (Amount Rs)
(iv) Write comments

Sales 21,00,000
Variable Cost 15,00,000
Fixed Cost 1,00,000
Interest 1,40,000
Tax Rate 30%

42
Solution – 10
Combined Leverage

Income Statement for the year ended 31.3.2015

Sales 21,00,000
Less : Variable cost 15,00,000
Contribution 6,00,000
Less : Fixed Cost 1,00,000
PBIT (or) EBIT 5,00,000
Less : Interest 1,40,000
PBT 3,60,000
Less : Tax (3,60,000 x 30%) 1,08,000
Profit after tax (PAT) 2,52,000

(i) Operating Leverge (OL) =

Contribution / PBIT =
6,00,000 / 5,00,000 = 1.2 times

(ii) Financial Leverage (FL) =

PBIT / PBT =
5,00,000 / 3,60,000 = 1.39 times

(iii) Combined Leverage (CL) =

Contribution / PBT =
6,00,000 / 3,60,000 = 1.67 times

Alternatively, as under :
CL = OL x FL =
1.2 x 1.39 = 1.67 times

Comments :

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Problem-11 (MMS, MU, May 2012)
(assignment)
Combined Leverage:

ABC Co. has sales of Rs 10,00,000. Variable cost is

70% of sales. Total cost is Rs 9,00,000 and debt of
Rs 5,00,000 at 10% rate of interest. If tax rate is 40%.
Calculate : (i) Operating Leverage,
(ii) Financial Leverage, and
(iii) Combined Leverage of the company.
(iv) Write comments.
Note : Total Cost : Rs 9,00,000.
Variable Cost = Rs 7,00,000
Fixed Cost = Total Cost (-) Variable Cost = (TC – VC) =
9,00,000 (-) 7,00,000 = Rs 2,00,000
FC = 2,00,000 (see next page)

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Solution – 11 : (important problem)
Income Statement for the year ended on ………
Amount Rs
Sales 10,00,000
Less : Variable Cost 7,00,000
Contribution 3,00,000
Less : Fixed Cost (see previous page) 2,00,000
EBIT (or) PBIT 1,00,000
Less : Interest (500000 x 10%) 50,000
PBT 50,000
Less : Tax (50,000 x 40%) 20,000
PAT 30,000
(i) Operating Leverage (OL ) =
Contribution / EBIT =
3,00,000 / 1,00,000 = 3 times

(ii) Financial Leverage (FL) =

EBIT / EBT = 1,00,000/50,000 = 2 times

(iii) Combined Leverage (CL) =

Contribution / EBT =
3,00,000 / 50,000 = 6 times

Another method :
CL = OL x FL = 3 x 2 = 6 times

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Problem-12 (assignment) :
Combined Leverage

(i) Find Operating Leverage from the following data:

Sales 50,000
Variable cost 60%
Fixed Cost 12,000
(ii) Find Financial Leverage from following data :
Net Worth (Equity) 25,00,000
Debt / Equity 3:1
Interest rate 12%
Operating Profit (EBIT) 20,00,000
(iii) Find Combined Leverage from above data
(iv) Write comments.

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Solution-12
(i) Calculation of Operating Leverage :
Statement of Operating Profit Amount Rs
Sales 50,000
Less : Variable cost (60% of 50,000) 30,000
Contribution (C ) 20,000
Less : Fixed Cost 12,000
Operating Profit (EBIT) 8,000
Operating Leverage (OL)=
Contribution / EBIT =
OL = 20,000 / 8,000 = 2.5 times

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(ii) Calculation of Financial Leverage :
Given, Net worth (Equity) = 25,00,000
Debt / Equity Ratio = 3 : 1
Debt = Networth x (Debt / Equity) =
25,00,000 x (3 /1) = 75,00,000
Interest @ 12% on debt =
75,00,000 x (12 / 100) = 9,00,000
EBIT (-) Interest = PBT (or) EBT
20,00,000 (-) 9,00,000 = 11,00,000
Financial Leverage (FL) =
EBIT / PBT =
20,00,000 / 11,00,000 = 1.818 = 1.8 times

(iii) Combined Leverage (CL) =

CL = OL x FL =
2.5 x 1.818 = 4.545 = 4.5 times

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Problem-13 (assignment) :
Calculate Operating Leverage, Financial Leverage, and Combined Leverage
for the following companies and interpret the results.
Write comments for your answer.

Description A Ltd B Ltd C Ltd

Output (units) 60,000 15,000 1,00,000
Fixed Cost (Rs) 7,000 14,000 1,500
Variable cost per unit (Rs) 0.20 1.50 0.02
Interest on borrowed capital (Rs) 4,000 8,000 0
Selling price per unit (Rs) 0.60 5.00 0.10

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Solution - 13
Description A Ltd B Ltd C Ltd
Output (units) 60,000 15,000 1,00,000
  Amount Rs Rs Rs
Selling price per unit 0.60 5.00 0.10
Less : Variable cost per unit 0.20 1.50 0.02
Contribution (C ) 0.40 3.50 0.08
Total Contribution (C x units) 24,000 52,500 8,000
Less : Fixed Costs 7,000 14,000 1,500
EBIT (or) Operating Profit 17,000 38,500 6,500
Less : Interest 4,000 8,000 0
Profit before tax (PBT) 13,000 30,500 6,500
(i) Operating Leverage (OL) =      
Contribution / EBIT = 24000/17000 52500/38500 8000/6500
OL = 1.41 1.36 1.23

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(ii) Financial Leverage (FL) =      
EBIT / PBT 17000/13000 38500/30500 6500/6500
FL = 1.31 1.26 1.00
(iii) Combined Leverage =      
Contribution / PBT 24000/13000 52500/30500 8000/6500
CL = 1.85 1.72 1.23
       
Another method for CL = OL x FL 1.41 x 1.31 = 1.36 x 1.26 = 1.23 x 1.00 =
CL = 1.85 1.72 1.23
 Comments :      

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Problem – 14 (home work) :
Financial Leverage : 4
Interest : Rs 45,000
Calculate EBIT
Solution - 14 :
FL = EBIT / EBT = 4 = 4/1
EBIT – EBT = Interest = Rs 45,000
But, 4 times EBT = 1 time EBIT (since FL = 4/1 = 4 as above)
Substitute, EBT for EBIT
Therefore, 4 EBT – 1 EBIT = 4 EBT – 1 EBT = Rs 45,000
3 EBT = 45,000
EBT = 45,000 / 3 = 15,000
EBIT = 4 times EBT = 4 x 15,000 = Rs 60,000
EBIT = Rs 60,000 (to check : FL = EBIT / EBT = 60,000 / 15,000 = 4)

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• Importance of Leverages :
Leverages have the magnifying effect. Operating leverage
magnifies EBIT with respect to contribution while financial
leverage magnifies EPS with respect to EBIT. Financial leverage
enhances the EPS without an additional investment. By having
judicious assets mix and financing mix, EPS may be increased. A
few areas identified in this regard are as follows :
(i) Investment in fixed assets (Operating leverage)
(ii) Capital structure planning (financial leverage)
(iii) Profit planning (combined leverage)
(iv) Monitoring business and financial risk
(v) Maximising the value of share by improving EPS
(vi) Appropriate and judicious mixture of operating leverage and
financial leverage.

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 A company (firm) with high operating leverage should not have
a high financial leverage. If both leverages are increased, the
possibility of bearing more risk will increase.

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THANK YOU

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