![Thus the degree of financial leverage (DFL) is ratio between proportionate change in EPS and
proportionate change in EBIT.
DFL = Earning before interest and tax (EBIT)
Earning after interest (EBT)
(iii) Combined Leverage
A combination of the operating and financial leverages is the total or Combination Leverage.
The operating leverage causes a magnified effect of the change in sales level on the EBIT level and if the financial leverage
combined simultaneously, then the change in EBIT will, in turn, have a magnified effect on the EPS. A firm will have wide
fluctuations in the EPS for even a small change in the sales level. Thus effect of change in sales level on the EPS is known
as combined leverage.
Thus Degree of Combined Leverage may be calculated as follows:
DCL = Contribution [C]
Earning after interest [EBT]](https://image.slidesharecdn.com/unit3leverageanalysis-240502064407-1d6a6e94/85/UNIT-3-CAPITAL-STRUCTURE-THEORY-AND-LEVERAGE-ANALYSIS-5-320.jpg)
UNIT 3 CAPITAL STRUCTURE THEORY AND LEVERAGE ANALYSIS
- 1. LEVERAGE ANALYSIS Leverage is the use of fixed assets in order to increase profitability. The concept of leverage has its origin in science. It means influence of one force over another. Since financial items are inter-related, change in one, causes change in profit. In the context of financial management, the term ‘leverage’ means sensitiveness of one financial variable to change in another. The measure of this sensitiveness is expressed as a ratio and is called degree of leverage. Algebraically, the leverage may be defined as, Leverage = % change in one variable___ % change in some other variable
- 2. Measures of Leverage To understand the concept of leverage, it is imperative to understand the three measures of Leverage which are as follows: (i) Operating Leverage (ii) Financial Leverage (iii) Combined Leverage (i) Operating Leverage: Operating Leverage is the leverage arising from fixed operating costs. Operating Leverage reflects the impact of change in sales on the level of operating profits of the firm. The significance of DOL may be interpreted as follows: Other things remaining constant, higher the DOL, higher will be the change in EBIT for same change in number of units sold in, if firm A has higher DOL than firm B, profits of firm A will increase at faster rate than that of firm B for same increase in demand. This however works both ways and so losses of firm A will increase at faster rate than that of firm B for same fall in demand. This means higher the DOL, more is the risk.
- 3. DOL is high where contribution is high. There is a unique DOL for each level of output. Thus, DOL = Contribution EBIT Illustration 3: Calculate the Degree of Operating Leverage (DOL), for the following firms and interpret the results. Firm K Firm L Firm M 1. Output (Units) 60,000 15,000 1,00,000 2. Fixed costs 7,000 14,000 1,500 3. Variable cost per unit 0.20 1.50 0.02 4. Interest on borrowed funds 4,000 8,000 - 5. Selling price per unit 0.60 5.00 0.10
- 4. (ii) Financial Leverage: The Financial Leverage may be defined as a % increase in EPS associated with a given percentage increase in the level of EBIT. Financial leverage emerges as a result of fixed financial charge against the operating profits of the firm. The fixed financial charge appears in case the funds requirement of the firm are partly financed by the debt financing. By using this relatively cheaper source of finance, in the debt financing, the firm is able to magnify the effect of change in EBIT on the level of EPS. The significance of DFL may be interpreted as follows : • Other things remaining constant, higher the DFL, higher will be the change in EPS for same change in EBIT. In other words, if firm K has higher DFL than firm L, EPS of firm K increases at faster rate than that of firm L for same increase in EBIT. However, EPS of firm K falls at a faster rate than that of firm K for same fall in EBIT. This means, higher the DFL more is the risk. • Higher the interest burden, higher is the DFL, which means more a firm borrows more is its risk. • Since DFL depends on interest burden, it indicates risk inherent in a particular capital mix, and hence the name financial leverage.
- 5. Thus the degree of financial leverage (DFL) is ratio between proportionate change in EPS and proportionate change in EBIT. DFL = Earning before interest and tax (EBIT) Earning after interest (EBT) (iii) Combined Leverage A combination of the operating and financial leverages is the total or Combination Leverage. The operating leverage causes a magnified effect of the change in sales level on the EBIT level and if the financial leverage combined simultaneously, then the change in EBIT will, in turn, have a magnified effect on the EPS. A firm will have wide fluctuations in the EPS for even a small change in the sales level. Thus effect of change in sales level on the EPS is known as combined leverage. Thus Degree of Combined Leverage may be calculated as follows: DCL = Contribution [C] Earning after interest [EBT]