Leverage Analyses and EBIT-EPS Analysis | CMA Inter Syllabus
Table of content
CMA Inter Blogs :
When a lever is used properly, a force applied at one point is transformed, or magnified, into another, larger force or motion at some other point. This comes most readily to mind when considering mechanical leverage, such as that which occurs when using a crowbar. In a business context, however, leverage refers to the use of fixed costs in an attempt to increase (or lever up) profitability. In this chapter we explore the principles of both operating leverage and financial leverage. The former is due to fixed operating costs associated with the production of goods or services, whereas the latter is due to the existence of fixed financing costs – in particular, interest on debt. Both types of leverage affect the level and variability of the firm’s after-tax earnings, and hence the firm’s overall risk and return.
Leverage is used to describe the firm’s ability to use fixed cost assets or funds to magnify the return to its owner James van Home has defined leverage, as “the employment of an asset or funds for which the firm pays a fixed cost or fixed return.” In other words, Leverage is the employment of fixed assets or funds for which a firm has to meet fixed costs or fixed rate of interest obligation irrespective of the level of activities or the level of operating profit.
With the understanding of leverage, a finance manager can increase earnings per share and dividend per share to equity shareholders as well as market value of the firm. When the rate of return on investment is more than the cost of debt capital, it gives more rate of return on equity capital. This in turn maximises shareholders’ wealth, which is the basic objective of financial management. The leverage can help increase both the EPS and EBT.
The importances of leverage are discussed below:
In leverage analysis, it is assumed that cost of capital always remains constant. But, after a certain limit, the cost of financing generally starts increasing. The use of more debt capital increases the risk level in a firm which results in reduction in the value of shares. Thus, in leverage analysis, explicit cost of debt capital is considered, while its implicit costs are ignored. Leverage principle assumes that the required additional debt capital should be raised till the expected rate of return on investment is higher than cost of debt capital.
There are three commonly used measures of leverages in financial analysis. These are:
a. Operating Leverage
Operating leverage is actually the use of fixed operating costs by the firm. Operating leverage is defined as “the firm’s ability to use fixed operating costs to magnify effects of changes in sales on its Earnings Before Interest and Taxes”. In other words, operating leverage is the tendency of the operating profit to vary disproportionately with sales. It is said to exist when a firm has to pay fixed cost regardless of volume of output or sales.
The operating leverage shows the relationship between the changes in sales and the changes in fixed operating income. Thus, the operating leverage has an impact mainly on fixed costs and also on variable costs and contribution. Of course, there will be no operating leverage if there are no fixed operating costs.
Operating leverage is present any time a firm has fixed operating costs – regardless of volume. In the long run, of course, all costs are variable. Consequently, our analysis necessarily involves the short run. We incur fixed operating costs in the hope that sales volume will produce revenues more than sufficient to cover all fixed and variable operating costs. One of the more dramatic examples of an effect of operating leverage is the airline industry, where a large proportion of total operating costs is fixed. Beyond a certain break-even load factor, each additional passenger essentially represents straight operating profit (Earnings Before Interest and Taxes, or EBIT) to the airline.
Degree of Operating Leverage (DOL)
Earlier, we said that one potential effect of operating leverage is that a change in the volume of sales results in a more than proportional change in operating profit (or loss). A quantitative measure of this sensitivity of a firm’s operating profit to a change in the firm’s sales is called the degree of operating leverage (DOL). The degree of operating leverage DOL of a firm at a particular level of output (or sales) is simply the percentage change in operating profit over the percentage change in output (or sales) that causes the change in profits. In other words, Degree of Operating Leverage DOL measures the sensitivity of a company’s operating income with changes in sales; a higher DOL implies a higher proportion of fixed cost in the business operations, whereas lower DOL implies lower fixed cost investment in running the business.
| The formula of Degree of Operating Leverage (DOL) is represented as, |
| Degree of Operating Leverage (DOL) = (Sales – Variable cost) / (Sales – Fixed Cost – Variable Cost) |
| = Contribution / EBIT |
| OR, |
| {EBIT + Fixed Cost } / EBIT or, 1 + { Fixed Cost / EBIT } |
| OR, |
| Degree of Opening Leverage (DOL) = Percentage change in EBIT / Percentage change in Sales |
| Note: Operating leverage affects a firm’s operating profit (EBIT). |
Relationship between Operating Leverage and CVP Analysis
There is a relation between Operating Leverage and CPV.
We know that,
Margin of Safety (MOS) = Actual Sales (S) – Break-Even Sales (BES)
Again, Margin of Safety Ratio (MOSR) = (S-BES) / S
= 1 – BES / S
= 1 – (F / PV Ratio) / S
[F = Fixed Cost, PV Ratio= Profit-Volume Ratio, BES = Fixed Cost / Profit-Volume Ratio]
= 1 – (F / C / S) / S
[C = Contribution, PV Ratio = Contribution / Sales]
= 1 – (F / C)
= (C – F) / C
= EBIT / C
= 1 / (C / EBIT)
= 1 / DOL [since DOL = C / EBIT, DOL = Degree of Operating Leverage]
So, it is evident that there exists an inverse relationship between DOL and margin of safety. It implies that with an increase in DOL margin of safety decreases and vice versa
Illustration 9
Calculate the operating leverage for each of the four firms, A, B, C and D from the following price and cost data. What conclusions can you draw with respect to levels of fixed cost and the degree of operating leverage DOL result? Explain. Assume number of units sold is 5,000.
| Firms | ||||
| A (₹) | B (₹) | C (₹) | D (₹) | |
| Sale Price per Unit (₹) | 20 | 32 | 50 | 70 |
| Variable Cost per Unit (₹) | 6 | 16 | 20 | 50 |
| Fixed Operating Cost (₹) | 80,000 | 40,000 | 2,00,000 | NIL |
Solution:
b. Financial Leverage
Financial leverage is actually the use of fixed financing costs by the firm. The financial leverage is defined as the ability of a firm to use fixed financial charges to magnify the effects of changes in operating profits, on the firm’s earning per share. In other words, the financial leverage is the tendency of a residual net income to vary disproportionately with operating profit. It indicates the change that takes place in the taxable income as a result of change in the operating income.
The British expression is gearing. Financial leverage involves the use of fixed cost financing. Interestingly, financial leverage is acquired by choice, but operating leverage sometimes is not. The amount of operating leverage (the amount of fixed operating costs) employed by a firm is sometimes dictated by the physical requirements of the firm’s operations. For example, a steel mill by way of its heavy investment in plant and equipment will have a large fixed operating cost component consisting of depreciation. Financial leverage, on the other hand, is always a choice item. No firm is required to have any long-term debt or preferred stock financing. Firms can, instead, finance operations and capital expenditures from internal sources and the issuance of common stock. Nevertheless, it is a rare firm that has no financial leverage.
The most commonly used measure of financial leverages are:
i. Debt ratio = Debt / Total Capital (V) = Debt (D) / Debt (D) + Shareholders Equity (E)
ii. Debt-Equity Ratio = Debt(D) / Sharehoders Equity (E)
iii. Interest Coverage Ratio = EBIT / Interest
Degree of Financial Leverage (DFL)
A quantitative measure of the sensitivity of a firm’s earnings per share to a change in the firm’s operating profit is called the degree of financial leverage (DFL). The degree of financial leverage DFL at a particular level of operating profit is simply the percentage change in earnings per share over the percentage change in operating profit that causes the change in earnings per share.
| The formula of Degree of Financial Leverage (DFL) is represented as, |
| Degree of Financial Leverage (DFL) = EBIT / EBT |
| OR, |
| Degree of FInancial Leverage (DFL) = Percentage chnage in Earnings per Share / Percentage chnage in Operating Profit (EBIT) |
| Note: (i) Financial leverage is the chnage in the level of EPS due to chnage EBIT. |
| (ii) FInancial leverage occours die to presence of fixed financial cost (Interest) in the buisness. |
Illustration 10
A company uses the DFL formula as DFL = EBIT and finds DFL when EBIT = ₹ 2,06,000 and EBT = EBT ₹ 1,72,000.
Solution:
c. Combined Leverage or Total Leverage
Combined leverage is a leverage which refers to high profits due to fixed costs. It includes fixed operating expenses with fixed financial expenses. It indicates leverage benefits and risks which are in fixed quantity. The degrees of operating and financial leverages are combined to see the effect of total leverage on EPS associated with a given change in sales.
| Computationally, we can make use of the fact that the degree of total leverage is simply the product of the degree of operating leverage and the degree of fiancial leverage as follows: |
| Degree of Combined Leverage (DCL) = ( Combined / EBIT ) x ( EBIT / EBT ) |
| = Contribution / EBT |
| OR, |
| Degree of Combined Leverage (DCL) = {%Change in EBIT / %Chnage in Sales} x {%Change in EPS / %Change in EBIT} |
| = %Change in EPS / %Change in Sales |
For eample, if operating leverage of a firm= 1.4 whereas financial leverage = 2, then the degree of combined leverage equals 1.4 × 2 = 2.8.
Illustreation 11
The ABC Ltd. has the following balance sheet and income statement information:
| Balance sheet as on March 31, 2021 | |||
| Liabilities | Amount (₹) | Assets | Amount (₹) |
| Equity capital (₹ 10 per share) | 8,00,000 | ||
| 10% Debt | 6,00,000 | Net fixed assets | 10,00,000 |
| Retained earnings | 3,50,000 | Current assets | 9,00,000 |
| Current liabilities | 1,50,000 | ||
| Total | 19,00,000 | 19,00,000 | |
| Income statement for the year ending March 2021 | |
| Particulars | Amount (₹) |
| Sales | 3,40,000 |
| Operating Expenses (including ₹ 60,000 depreciation) | 1,20,000 |
| EBIT | 2,20,000 |
| Less: Interest | 60,000 |
| Earning Before Tax (EBT) | 1,60,000 |
| Less: Taxes | 56,000 |
| Net Earnings After Tax (EAT) | 1,04,000 |
a. Determine the degree of operating, financial and combined leverages at the current sales level, if all operating expenses, other than depreciation, are variable costs.
b. If total assets remain at the same level, but sales (i) increase by 20% and (ii) decrease by 20%, what will be the earnings per share in the new situation?
Solution:
Illustration 12
A firm’s sales, variable costs and fixed cost amount to ₹ 75 lakh, ₹ 42 lakh and ₹ 6 lakh respectively. It has borrowed ₹ 45 lakh at 9% and its equity capital totals ₹ 55 lakh.
Solution:
The indifference point refers to that level of EBIT at which EPS are the same regardless of leverage in alternative financial plans. At this level, all financial plans are equally desirable and the management is indifferent between alternative financial plans as far as the EPS is concerned.
In other words, it is that level of EBIT at which it is immaterial for the financial manager as to which capital structure or capital mix he adopts for the company. At this point, the use of debt capital or a change in this proportion in the total capital will not affect the return to equity shareholders or earning per share.
The determination of indifference points helps in ascertaining the level of operating profit (EBIT) beyond which the debt alternative is beneficial because of its favourable effect on earnings per share.
Futhermore, it is profitable to raise debt for strengthening EPS, if there is likelihood that future operating profits are going to be higher than the level of EBIT as determined. On the other hand, it is advisable to issue equity shares for raising more funds if it is expected that EBIT is going to be lower than that determined.
Illustration 13
Excel Limited is considering three financing plans. The key information are as follows:
a. Total funds to be raised, ₹ 2,00,000.
b. Financing plans
| Plans | Equity (%) | Debt (%) | Prefernce (%) |
| A | 100 | - | - |
| B | 50 | 50 | - |
| C | 50 | - | 50 |
c. Cost of debt 8%; cost of preference shares 8%.
d. Tax rate, 35%.
e. Equity shares of the face value of ₹ 10 each will be issued at a premium of ₹ 10 per
f. Expected EBIT, ₹ 80,000.
Determine for each plan:
Solution:
The EBIT-EPS analysis is carried out to assess the impact of different financial proposals on the value (EPS) of the company. Since the basic aim of financial management is to maximise the wealth of shareholders, the EBIT- EPS analysis is crucial in maximising the wealth of the company.
The financial proposal having the highest EPS is considered for the execution. The different financial proposals may be the use of, only equity, combination of equity and debt, combination of equity and preferential capital, or any combination of equity, debt and preferential capital. EBIT-EPS analysis shows the impact of financial leverage on the EPS of the company under different financial proposals.
Illustration 14
The selected financial data for A, B and C companies for the current year ended March 31, 2021 are as follows:
| Particulars | A | B | C |
| Variable expenses as a percentage of sales | 66.67 | 75 | 50 |
| Interest expenses (₹) | 200 | 300 | 1000 |
| Degree of operating leverage (DOL) | 5 | 6 | 2 |
| Degree of financial leverage (DFL) | 3 | 4 | 2 |
| Income-tax rate | 0.35 | 0.35 | 0.35 |
Solution:
Illustration 15
Calculate (a) the operating leverage, (b) financial leverage and (c) combined leverage from the following data under situations I and II and financial plans, A and B.
Under situation I - ₹ 1,50,000
Under situation II - ₹ 2,00,000
| Particulars | Plan A (₹) | Plan A (₹) |
| Equity | 1,00,000 | 1,50,000 |
| Debt (Interest 20%) | 1,00,000 | 50,000 |
| Total | 2,00,000 | 2,00,000 |
Solution:
Illustration 16
Calculate operating leverage and financial leverage under situations A, B and C and financial plans 1, 2 and 3 respectively from the following information relating to the operation and capital structure of X, Y, Z Ltd. Also find out the combinations of operating and financial leverage which give the highest value and the least value.
| Installed capacity (units) | 1,200 |
| Actual production and sales (unit) | 800 |
| Selling price unit (₹) | 15 |
| Varaible cost per unit (₹) | 10 |
| Fixed costs (₹ ): | |
| Situation A | 1,000 |
| Situation B | 2,000 |
| Situation C | 3,000 |
| Particulars | Financial Plan | ||
| 1 (₹ ) | 2(₹ ) | 3(₹ ) | |
| Equity (₹ ) | 5,000 | 7,500 | 2,500 |
| Debt (₹ ) | 5,000 | 2,500 | 7,500 |
| Cost of debt (for all plans) (%) | 12 | ||
Solution:
Illustration 17
The XYZ Company plans to expand assets by 50%. To finance the expansion, it is choosing between a straight 6% debt issue and equity issue. Its current balance sheet and income statement are shown below:
Balance Sheet of XYZ company as on March 31, 2020
| Particulars | Amount (₹) | Particulars | Amount (₹) |
| 5% Debt | 4,00,000 | Total assets | 20,00,000 |
| Equity shares (₹ 10 per share) | 10,00,000 | ||
| 6,00,000 | |||
| Total | 20,00,000 | Total | 20,00,000 |
Income Statement for the year ended March 31,2020
| Particulars | Amount (₹) |
| Sales | 60,00,000 |
| Total cost (excluding interest) | 53,80,000 |
| EBIT | 6,20,000 |
| Less: Interest on debt | 20,000 |
| EBT | 6,00,000 |
| Less: Taxes | 2,10,000 |
| Net income | 3,90,000 |
If company finances the proposed expansion with debt, the rate on the incremental debt will be 6% and the price / earnings ratio of the equity shares will be 10. If expansion is financed by equity, the new shares can be sold at ₹ 33.33 and the price/earnings ratio of all the outstanding equity shares will remain 12.
Solution:
A. Theoritical Questions
1. Operating leverage helps in analysis of:
Answer: a. Buisness Risk
2. Which of the following is studied with the help of financial leverage?
Answer: d. Financing Risk
3. Combined Leverage is obtained from OL and FL by their:
Answer: c. Multiplication
4. High degree of financial leverage means:
Answer: a. High debt proportion
5. Operating leverage arises because of:
Answer: a. Fixed Cost of Production
6. Financial Leverage arises because of:
Answer: c. Interest Cost
7. Operating Leverage is calculated as:
Answer: a. Contribution ÷ EBIT
8. Financial Leverage is calculated as:
Answer: b. EBIT÷ PBT
9. Which combination is generally good for firms
Answer: c. High OL, Low FL
10. Combined leverage can be used to measure the relationship between:
Answer: c. Sales and EPS
11. FL is zero if:
Answer: b. EBIT = Zero
12. Business risk can be measured by:
Answer: b. Operating leverage
13. Financial Leverage measures relationship between
Answer: b. EBIT andd EPS
14. Use of Preference Share Capital in Capital structure
Answer: b. Increase FL
15. Relationship between change in sales and change m is measured by:
Answer: b. Combined leverage
16. Operating leverage works when:
Answer: c. Both (a) and (b)
17. Which of the following is correct?
Answer: c. OL = OL x FL
18. If the fixed cost of production is zero, which one of the following is correct?
Answer: d. None of the above
19. If a firm has no debt, which one is correct?
Answer: b. FL is one
20. If a company issues new share capital to redeem debentures, then:
Answer: d. FL will decrease
21. If a firm has a DOL of 2.8, it means:
Answer: c. If sales rise by 1%, EBIT will rise by 8%
22. Higher OL is related to the use of higher:
Answer: c. Fixed Cost
23. Higher FL is related the use of:
Answer: b. higher Debt
24. The degree of operating leverage and degree of financial leverage of VINTEX are 2.00 and 1.5 respectively. What will be the percentage change in EPS, if the sale increases by 10%?
Answer: c. 30% increase
25. The Degree of Operating Leverage (DOL) and the Degree of Financial Leverage of ALANTA LTD. are 3 and 67 respectively. If the management of the company targets to increase the EPS by 10 %, by how much percentage should sales volume be increased? (Rounded off your answer to the nearest value.)
Answer: d. 2.00%
B. Numerical Questions:
1. The oprating and cost data of ABC Ltd are:
| Sales | ₹ 20,00,000 |
| Variable costs | 14,00,000 |
| Fixed costs | 4,00,000 (including 15% interest on ₹ 10,00,000) |
Calculate its operating, financial and combined leverage.
Answer:
1. From the following data, calculate DOL and DFL, and DTL (degree of total leverage). Given the selling price is ₹ 2 per unit, fixed cost is ₹ 1,00,000 and variable cost is ₹ 7 per unit and the number of units is 1,00,000.
Answer:
2. From the following data, calculate percentage change in EPS if sales are expected to increase by 5%:
| EBIT | ₹ 10,00,000 |
| PBT | ₹ 4,00,000 |
| Fixed Cost | ₹ 6,00,000 |
Answer:
3. From the following data of four firms, calculate the EPS, the DOL and the DFL:
| Firm - P | Firm - Q | Firm - R | Firm - S | |
| Sales (in units) | 20,000 | 25,000 | 30,000 | 40,000 |
| Selling price per unit (₹) | 15 | 20 | 25 | 30 |
| Variable cost per unit (₹) | 10 | 15 | 20 | 25 |
| Fixed cost (₹) | 30,000 | 40,000 | 50,000 | 60,000 |
| Interest (₹) | 15,000 | 25,000 | 35,000 | 40,000 |
| Tax (%) | 40 | 40 | 40 | 40 |
| Number of equity shares | 5,000 | 9,000 | 10,000 | 12,000 |
Answer:
Ruchika Saboo
An All India Ranker (AIR 7 - CA Finals, AIR 43 - CA Inter), she is one of those teachers who just loved studying as a student. Aims to bring the same drive in her students.
Ruchika Ma'am has been a meritorious student throughout her student life. She is one of those who did not study from exam point of view or out of fear but because of the fact that she JUST LOVED STUDYING. When she says - love what you study, it has a deeper meaning.
She believes - "When you study, you get wise, you obtain knowledge. A knowledge that helps you in real life, in solving problems, finding opportunities. Implement what you study". She has a huge affinity for the Law Subject in particular and always encourages student to - "STUDY FROM THE BARE ACT, MAKE YOUR OWN INTERPRETATIONS". A rare practice that you will find in her video lectures as well.
She specializes in theory subjects - Law and Auditing.
Yashvardhan Saboo
A Story teller, passionate for simplifying complexities, techie. Perfectionist by heart, he is the founder of - Konceptca.
Yash Sir (As students call him fondly) is not a teacher per se. He is a story teller who specializes in simplifying things, connecting the dots and building a story behind everything he teaches. A firm believer of Real Teaching, according to him - "Real Teaching is not teaching standard methods but giving the power to students to develop his own methods".
He cleared his CA Finals in May 2011 and has been into teaching since. He started teaching CA, CS, 11th, 12th, B.Com, M.Com students in an offline mode until 2016 when Konceptca was launched. One of the pioneers in Online Education, he believes in providing a learning experience which is NEAT, SMOOTH and AFFORDABLE.
He specializes in practical subjects – Accounting, Costing, Taxation, Financial Management. With over 12 years of teaching experience (Online as well as Offline), he SURELY KNOWS IT ALL.
"Koncept perfectly justifies what it sounds, i.e, your concepts are meant to be cleared if you are a Konceptian. My experience with Koncept was amazing. The most striking experience that I went through was the the way Yash sir and Ruchika ma'am taught us in the lectures, making it very interesting and lucid. Another great feature of Koncept is that you get mentor calls which I think drives you to stay motivated and be disciplined. And of course it goes without saying that Yash sir has always been like a friend to me, giving me genuine guidance whenever I was in need. So once again I want to thank Koncept Education for all their efforts."
"Hello everyone, I am Kaushik Prajapati. I recently passed my CA Foundation Dec 23 exam in first attempt, That's possible only of proper guidance given by Yash sir and Ruchika ma'am. Koncept App provide me a video lectures, Notes and best thing about it is question bank. It contains PYP, RTP, MTP with soloution that help me easily score better marks in my exam. I really appericiate to Koncept team and I thankful to Koncept team."
"Hi. My name is Arka Das. I have cleared my CMA Foundation Exam. I cleared my 12th Board Exam from Bengali Medium and I had a very big language problem. Koncept Education has helped me a lot to overcome my language barrier. Their live sessions are really helpful. They have cleared my basic concepts. I think its a phenomenal app."
"I cleared my foundation examination in very first attempt with good marks in practical subject as well as theoretical subject this can be possible only because of koncept Education and the guidance that Yash sir has provide me, Thank you."
