Capital structure -leverage analysis.ppt
- 1. LEVERAGES
- 2. INTRODUCTION • Leverage refer to the amount of debt a firm uses to finance assets. • It arises from the existence of fixed costs. • It is an investment strategy to use borrowed money. • If a business is leveraged , it means that the firm has borrowed money to finance business.
- 3. CONTINUED • With larger presence of fixed cost profit margins can really get squeezed when the business scenario is not favorable and the sales fall. This adds risk to the stocks of such companies. • Conversely with the same larger presence of fixed cost company would experience magnified profits with increase in sales as the cost level remaining constant.
- 4. TYPES OF LEVERAGE 1. Operating Leverage - It arises with the presence of firm’s fixed operating costs such as salaries, rent, depreciation, utility expense etc. 2. Financial Leverage - It arises with the presence of firm’s fixed financing costs such as interest expenses on debt and preference shares. 3. Combined Leverage - Product of operating and financial leverage.
- 5. OPERATING LEVERAGE FINANCIAL LEVERAGE Relationship between operating - Relationship between operating Profit & Sales Profit & EPS Related to Assets - Related to Liabilities Related to Investment Decision - Related to Financing Decision Measures the ability of the firm - Measures the ability of the firm to use fixed cost assets to increase the to use fixed cost assets to increase operating profit the return on equity Shares First Stage Leverage - Second Stage Leverage DIFFERENCE
- 6. FORMULAS Sales – Variable cost = Contribution Contribution – Fixed cost = Earning Before Interest and Tax Earning before Interest and tax – Interest = Earning Before Tax Earning before tax – Tax = Earning After Tax Earnings after Tax – Preference dividend = Net Profit Earning per share = Net Profit / No. of Shares
- 7. FORMULA • Degree of Operating Leverage = Contribution / EBIT • Degree of Operating Leverage = % Change in EBIT/ % Change in sales • Degree of Financial Leverage = EBIT/ PBT • Degree of Financial Leverage = % Change in EPS / % Change in EBIT • Degree of Combined Leverage = OL * FL • Degree of Combined Leverage = % Change in EPS / % Change in Sales
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