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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 (1-t)
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= (EBIT-I) = 1800-200= 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
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