Leverage and its type
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This document discusses two types of leverage: operating leverage and financial leverage. Operating leverage is concerned with how fixed costs affect operating profits with changes in sales. It can be calculated using break-even analysis. Financial leverage refers to how the use of fixed financial charges, like interest and dividends, can magnify the effects of changes in earnings before interest and taxes (EBIT) on earnings per share. An example shows how to calculate financial leverage given information about a company's capital structure, EBIT, interest expenses, and preferred dividends.
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Leverage and its type
- 1. Presentation by – vinodsolanki
- 2. Types of leverage 1. Operating leverage :- Operating leverage concerned with the cost structure of a firm The change in operating profits after changing fixed cost is greater than the percentage change in sales ,is known as operating leverage Operating leverage can be determined by means of break – even analysis or cost-volume profit analysis at any level of sales in term of total sales contribution (sales –variblecost) Operating leverage = operating profit
- 3. Example : - calculate operating leverage from the following information interest 5000,sales 50,000,variable cost 25000,fixed cost 15000 sales-variable cost operating leverage= EBIT EBIT= sales-variable cost-fixed cost 50000-25000-10000 = 15000 = 50000-25000 15000
- 4. Financial leverage Financial leverage knows as trading or equity it defined as the the ability of a firm to use fixed financial charges to magnify the effects of changes in ebit on earnings per share EBIT Financial leverage = PBT
- 5. Example : - a company has the following capital structure equity share capital 100,000 10%preference share capital 100000 8% debetntures 125000 Solution Operating profit or EBIT 50000 Less: interest on debenture 10000 Pref.dividend(per-tax basis) 10000 total 30000
- 6. EBIT Financial leverage = PBT = 50000 30000 =1.67