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leverage 
leverage 
January 30th, 2010
Q2. What is combined leverage? What does it measure? What would be the changes in the degree of combined leverage assuming other things being equal, in following situations? (a) The fixed cost increases (b) the EBIT level increases (c) the sale price decreases & (d) the variable cost decreases? A2. The term leverage refers to the relation between two interrelated variables. With reference to a business firm these variables may be cost, output, sales revenue, EBIT, earning per share etc In financial analysis, the leverage reflects the influence of one financial variable over other financial variable. OPERATING LEVERAGE when the sales level increases or decrease, the EBIT also changes. The operating leverage measures the relation between the sales revenue and the EBIT or in other words, it measures the effect of change in sales revenue on the level of EBIT. Operating leverage is computed by dividing % change in EBIT by the % change in sales revenue. Operating leverage = % change in EBIT % change in sales revenue DOL = C/ OP Where, C= (SALES IN VARIABLE COST) OP= EBIT FINANCIAL LEVERAGE the financial leverage (FL) measures the relation between the EBIT & the EPS & it reflects the effect of change in EBIT on the levels of EPS. The FL measures the responsiveness of the EPS to a change in EBIT & is defined as the % change in EPS divided by % change in EBIT. SYMBOLICALLY Financial leverage = % change in EPS / % change in EBIT = increase in EPS / EPS Increase in EBIT / EBIT Where EPS= (EBIT Interest) x (1t) No. of shares It may be noted that the EBIT is a dependent variable in the OL & was determined by sales level. However in case of the FL, the EBIT is an independent variable & now is determining the level of EPS. That is why that EBIT is called a linking point in the leverage study. FL= OP/ PBT or FL= EBIT/ (EBIT I) Where, OP= operating Profit or EBIT PBT= profit before tax & after interest. COMBINED LEVERAGE The combined leverage (CL) is not a distinct type of leverage analysis; rather it is a product of operating leverage (OL) & financial leverage (FL). So far the OL & FL have been analyzed separately. The OL explains the business risk complexion of the firm whereas the FL deals with the financial risk of the firm. But a firm has to look into the overall risk or total risk of the firm, which is business risk plus the financial risk. Therefore a financial manager should consider both the FL & OL simultaneously. The OL causes a magnified effect of the change in sales level on the EBIT level & if the FL is also considered simultaneously then the change in EBIT will have a magnified effect on EPS. Thus a firm having both the FL & OL will have wide fluctuations in the EPS for even a small change in the sales level. This effect of change in the sales level of EPS is known as combined leverage. The effect of OL & FL are collectively captured through the concept of combined leverage (CL). Combined leverage can be described as the capacity of the firm to magnify its EPS as its sales rise. This magnification is possible because the firm has fixed operating costs in its cost structure & fixed finance charges in its capital structure. CL= OL x FL =C x EBIT EBIT (EBIT I)/ NI = C/NI WHERE, C= contribution contribution= sales variable cost NI= net income after interest EBIT= operating income Degree of combined leverage: mathematically, DCL is defined as the change in EPS from the percentage change in sales. DCL= DOL * DFL % change in EBIT x % change in EPS % change in sales % change in EBIT Thus, DCL= % change in EPS % change in sales Or CL= Cn x OP = Cn OP PBT PBT Where, Cn= contribution= (sales variable cost) PBT= profit before tax Illustrations: Units sold Sales @Rs. 10 per unit () variable [email protected]/ unit. Contribution ()fixed cost EBIT () interest PBT TAX @ 50% Profit after tax Rs. 1000 10,000 (7000) 3,000 (1000) 2,000 (200) 1800 900 900 CL= C/PBT= 3000/1800 = 1.66 Changes in following situation: 1. Fixed cost increases: if fixed cost increases then it will increase the profit before tax. And thus will increase combined leverage. Say FC rises to 1200 C FC= EBIT =1800 Now, PBT= (EBITI) = 1800200= 1600 CL= C/PBT= 3000/1600=1.87 2. The EBIT level increases: increase in EBIT will have no effect on combined leverage. This is because the formula foe CL is contribution divided by profit before tax. There is no role of EBIT in this. 3. Sale price decreases: Contribution = sales – variable cost If sale price reduces ultimately total sales reduces. This will decrease the contribution. If contribution decreases then combined leverage also comes down. Say sale [email protected] Rs.11 Units sold Sales @Rs. 11 per unit () variable [email protected]/ unit. Contribution ()fixed cost EBIT () interest PBT Rs. 1000 11,000 (7000) 4,000 (1000) 3,000 (200) 2800 CL= 4000/2800= 1.42 4. Variable cost decreases: decrease in variable cost will increase the contribution. This will increase the combined leverage. Say VC= 8/unit Units sold Sales @Rs. 11 per unit () variable [email protected]/ unit. Contribution ()fixed cost EBIT () interest PBT Rs. 1000 11,000 (8000) 2,000 (1000) 1,000 (200) 800 CL= C/PBT= 2000/ 800 =2.5 Advertisements
 
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