Top 3 Ratios under Activity Leverage | Financial Leverages

There are three ratios under this head which merit mention:- 1. Operating Leverage 2. Financial Leverage 3. Total Leverage.

Ratio # 1. Operating Leverage:

Operating leverage is concerned with the operation of any firm. The cost structure of any firm gives rise to operating leverage because of the existence of fixed nature of costs. This leverage relates to the sales and profit variations. Sometimes a small fluctuation in sales, would have a great impact on profitability. This is because of the existence of fixed cost elements in the cost structure of a product.

Operating Leverage = Contribution/EBIT or Contribution/Operating profit

Operating leverage is the responsiveness of firm’s EBIT to the changes in sales value. It refers to the sensitivity of operating profit before interest and tax to the changes in quantity produced and sold. The firm’s operating leverage would be higher if the firm has high quantum of fixed cost and low variable cost.

The low operating leverage represents the high variable cost and low fixed cost. If the operating leverage of the firm is higher, the more its profits will vary with a given percentage in sales. The operating leverage is an attribute of the firm’s business risk.

The operating leverage falls with the increase in sales beyond the firm’s break-even point. A company with high proportion of fixed costs to total costs will have a high operating leverage. A company with a high operating leverage will have higher break-even level.

If contribution to sales ratio of a firm is high, it can achieve higher profitability at maximum operating level. In times of recession, the high operating leverage will act as a disadvantage to the firm for the reason that lower level of operating profits due to higher fixed costs. When there is a change of 1% in sales produces a more than 1% change in EBIT, there is a presence of operating leverage and this measure is called as ‘degree of operating leverage’.

Degree of Operating Leverage

Percentage change in EBIT/Percentage change in Sales or % ∆EBIT/% ∆Q

The Degree of Operating Leverage can also be expressed as follows:

DOL = Q (P – V)/Q(P – V) – F 

Where,

DOL = Degree of operating leverage

Q = Quantity produced and sold

P = Selling price per unit

V = Variable cost per unit

F = Operating fixed costs

There is a presence Operating Leverage in the firm if:

% ∆ EBIT/% ∆Q > 1

The degree of operating leverage measures the responsiveness of EBIT to change in level of output.

Ratio # 2. Financial Leverage:

This ratio indicates the effects on earnings by rise of fixed cost funds. It refers to the use of debt in the capital structure. Financial leverage arises when a firm deploys debt funds with fixed charge.

The ratio is expressed as follows:

Financial Leverage = EBIT/EBT

The higher the ratio, the lower the cushion for paying interest on borrowings. A low ratio indicates a low interest outflow and consequently lower borrowings. A high ratio is risky and constitutes a strain on profits. This ratio is considered along with the operating ratio, gives a fairly and accurate idea about the firm’s earnings, its fixed costs and the interest expenses on long-term borrowings.

The financial leverage is an indicator of responsiveness of firm’s EPS to the changes in its profit before interest and tax. It indicates the use of earnings in making payments for fixed interest and fixed dividend bearing securities.

EPS can be ascertained as below:

The degree of financial leverage measures the responsiveness of EPS to the changes in EBIT.

Degree of financial leverage can also be expressed as follows:

Where, DFL = Degree of financial leverage

EBIT = Earnings before interest and tax

t = Corporate Income-tax rate

I = Interest on long-term debt

D_p = Preference dividend

Illustration 1:

The following information is available for Crompton Ltd. for the year ended 31st March, 2009:

Interest on debt: Rs. 4,00,000

Preference dividend: Rs. 2,00,000

Corporate tax rate: 40%

Calculate the degree of financial leverage: (i) if EBIT is Rs. 10,00,000, and (ii) if EBIT is Rs. 15,00,000.

Solution:

Analysis:

If finance charges are fixed (constant), an increase in level of EBIT will reduce the degree of financial leverage and the firm’s financial risk would be lower.

Favourable or positive financial leverage occurs when the firm earns more on the assets purchased with the funds than the fixed financing cost paid. Excess of earnings over fixed costs goes to common shareholders. On the contrary, if the firm does not earn sufficient profits to cover financing costs, unfavourable or negative leverage is said to occur.

The Finance manager has to decide what amount of debt to use as a source of financing, instead of financing with stock. In case of debt financing, the definite payment of interest is made. It does not matter what the level of EBIT is, affecting the firm’s ability to make scheduled interest payments, but it will help to magnify earnings per share as volume or operating income increases.

Higher financial leverage leads to higher EBIT resulting in higher EPS, if other things (variables) remaining the same. Financial leverage affects the variability and expected level of EPS. The more debt the firm employs the higher its financial leverage. Financial leverage generally raises expected EPS, but it also increases the riskiness of securities as the Debt/Asset ratio rises.

A firm is said to be highly levered if the proportion of long-term debt and preferential share capital is high in relation to the equity share capital. In such case the interest payments and preference dividends would drastically reduce the pool available to the ordinary shareholders and their earnings per share falls. The situation is represented in figure 28.1

The relationship of financial leverage with cost Of capital and value of the firm is shown below:

Impact of Financial Leverage on ROE and RDA:

The impact of financial leverage on return on equity (ROE) is positive, if cost of debt (after tax) is less than return on assets (ROA).

ROA and ROE can be ascertained with the help of following formulas:

Where,

Capital employed = Shareholders funds + Loan funds

NOPAT = EBIT (1 – t)

D = Debt in capital structure

E = Equity capital in capital structure

K_d= Interest rate (1 – t)

Ratio # 3. Total Leverage:

Total leverage may be defined as the potential use of fixed costs, both operating and financial, which magnifies the effect of sales volume change on the EPS of the firm. The total leverage is also called as ‘combined leverage’.

The methods of production employed which are reflected in the asset structure of the firm, influence its operating leverage. For example, substituting machinery for labour usually increases operating leverage. The capital sources employed, which are reflected in the capital structure of the firm, influences its financial leverage. For example, substituting debt for common stock-holders equity increases financial leverage.

Degree of total leverage can be calculated as follows:

DTL = Operating Leverage x Financial Leverage

Substituting the value of EPS, we get:

Where, Q = Quantity produced and sold

V = Variable cost per unit

P = Selling price per unit

F = Fixed operating cost

I = Interest cost on debt

D_p = Preference dividend

t = Income-tax rate

DTL measures the sensitivity of EPS to change in quantity produced and sold.

Illustration 2:

 

 

 

 

 

A 5% change in sales will cause to change in EPS by 9.45% (i.e. 1.89 x 5%).

We combine operating leverage and financial leverage to assess the impact of all types of fixed costs on the firm. High operating leverage may be balanced off against lower financial leverage, if this is deemed desirable and vice versa.

On the other hand, dividend payment to shareholders can be cut in emergencies when the firm uses only stock in capital structure designing. A percentage change in EBIT results more than a proportionate change in earning per share.

The combined effect of different degrees of operating and financial leverage on the firm is explained as follows: