CHAPTER FIVE

LEVERAGE ANALYSIS

Learning Objectives:
After completing this chapter you will be able to:
1. Acquire an understanding of leverage ratios
2. Examine the consequences of financial leverage for a business firm
3. Explain the concepts of financial and operating leverage and examine the
relationship between the two.
4. Assess the risk implication of financial leverage.

5.1 Introduction
You have familiarized yourself with the various kinds of financial ratios – both
separately and in their broader groupings. Unit four of Ratio Analysis
introduced the four fundamental bases for ratios, viz., liquidity, leverage,
activity, and profitability. The ratios discussed in that chapter were picked
up on the basis of their relevance in controlling business activities.
Accordingly, the liquidity and leverage ratios were not covered.
Even though a firm’s management would always be interested in maintaining a
satisfactory level of liquidity and solvency, it is the lender or the banker who
would insist upon certain norms and would monitor movements in these
ratios.
Leverage ratios, which reflect the solvency status of a firm, are covered here in
detail. You will get an idea about the basic concepts of leverage and will be
exposed to the role and effects of financial leverage.

5.2 Concept of Financial Leverage

Consider for a movement the common use of the terms ‘level’ and ‘leverge’.
Webster’s dictionary defines them as follows:
“Lever’ is an inducing or compelling force.
“Leverage’ is the action of a lever or the mechanical advantage gained by it; it
also means ‘effectiveness’ or ‘power’.
The common interpretation of leverage is derived from the use or manipulation
of a tool or device termed as lever which provides a substantive clue to the
meaning and nature of financial leverage.

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Now, suppose we suggest that our lever is the use of debt or borrowed funds
in financing the acquisition of assets. Probably, you need a little explanation
Probably, you need a little explanation. We will do that. You have to look at the
following simple (and hypothetical) facts about the GTB (Gain Through
Borrowing) Limited Company.
The GTB limited wants to purchase fixed assets worth $800,000 for the
execution of a project which was to be financed by raising share capital of
$300,000 and term loan of $500,000 @18% interest. The company was
required to earn a minimum return of 20% on its share capital. Other
companies of this type were earning this much and unless GTB Limited
provided at least this return, no investor would be attracted to buy its shares.
The GTB Limited pays tax at 40% and is not required to pay any tax on the
interest charges on term-loans.
What happens to the company’s net returns (after interest and taxes) on
equity if: (a) the whole of $800,000 is financed by selling share capital; and (b)
the scheme of financing as envisaged in the problem is implemented? You may
assume GTB’s earnings power to be 40% (before interest and tax) on total
assets of $800,000 (i.e., $320,000; i.e., constant EBIT).
Let us see what happens to the earnings after interest and taxes under
the two plans:
Table 5.1
Effect of Financial Leverage
$800,000 as $300,000 of share capital
share capital plus $500,000 of Debt
@18%
Earnings on assets of $800,000 @40% $320,000 $320,000
Less: Interest !8% 0n $500,000 - 90,000
Earnings after Interest $320,000 $230,00
Taxes @ 40% $128,000 92,000
Earnings after Taxes $192,000 $138,000
Earnings after interest & taxes as a %
of share capital 24% 46%

The net return on equity is 24% when no debt is used but it is 46% when debt
is used. There is a considerable increase in the net return. At this juncture,
we would premise that the use of debt funds in a profit-making and tax-
planning business improves the net equity returns. The effect which the use
of debt funds produces on returns is called financial leverage.

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5.3 Measures of Financial Leverage
The financial leverage measures the effects of the changes in EBIT on the
EPS of the company.
The commonly used measures of financial leverage are:
(a) Debt Ratio: This is the proportion of long-term debt in the total capital
employed in the business.
DR = D
D+E
Where: E = book value of equity (i.e., shareholders funds)
D = book value of debt
This ratio indicates the extent to which the firm relies on debt as a source of
finance.
(b) Debt-Equity Ratio: This is the ratio of long-term debt to the
shareholders funds in the capital structure of the firm.
D-E Ratio = D
E
Where: E = book value of equity (i.e., shareholders funds)
D = book value of debt
This ratio indicates the extent to which the firm relies on debt as a source of
finance.
(c) Interest Coverage Ratio (ICR): This is measures the ability of the firm
to meet out its interest payment obligations. In other words, the ability to
pay the fixed financial charges.
ICR = EBIT
Interest
Impact of Financial Leverage on Investor’s Return and Risk: the equity
shareholders are the residual claims on the earnings of the firm. Two measures
of return that are important from the view point of shareholders are earnings
per share (EPS) and return on equity (ROE).

EPS = Profit After Taxes

Number of shares Outstanding
EPS = EBIT –I) (1 – T)
N

ROE = Profit After Taxes

Shareholders’ funds

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 5.3 Concept of Operating Leverage
We have stated and shown in the preceding section that Financial Leverage
magnifies the risk of bankruptcy, viz., the financial risk. Now, we have
another concept of leverage which has a close relationship with business risk.
This is operating leverage.
In a large number of situations, a firm would be in a position to exercise a
degree of control on the choice of its technology and the related
production processes. The production processes which are accompanied by
high fixed costs but low variable costs are generally the highly mechanized and
automated processes. With such processes, the degree of operating leverage if
generally high, the break-even point is relatively higher, and thus changes in
the sales levels have a magnified ( or “leveraged”) effect on profits.
Operating leverage refers to the use of fixed costs in the operation of a firm.
In other words, it implies the proportion of fixed costs in the total cost
structure of the firm. The higher the proportion of fixed costs in the total cost
structure the higher is the operating leverage. Fixed operating costs do not
include debt interest, which is fixed financial cost. On the other hand, it
includes costs such as administrative costs, depreciation, selling and
advertising expenses, etc. if there are no fixed costs, the firm has no operating
leverage.
Operating leverage is to measure operating risk. The risk arising out of
variability in earnings due to change in quantity produced and sold.
Operating leverage means, in simple language, the change in Earnings Before
Interest and Tax (EBIT) because of change in Q (quantity produced and sold).
Measure of operating leverage
(a) Fixed Costs/Total Cost Ratio: since we define operating leverage as the
proportion of fixed costs in the total cost structure, the ratio of fixed
costs to total costs can be used as a measure of operating leverage.
Operating Leverage = Fixed Costs
Total Costs

Impact of Operating Leverage on Operating Profits: Operating leverage

is a double-edged sword. Operating profits of a highly levered firm would
increase at a faster rate for any given increase in sales. However, if the sales
decline a firm with higher operating leverage would suffer more loss than a
firm with low operating leverage. This is so because fixed costs have to be
met irrespective of the level of revenues generated. When sales are

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 increasing, the fixed costs can easily be provided for and the remaining
sales revenue goes towards increasing the operating of the firm (assuming
that the variable cost to sales ratio of the firm is less than 1). But when the
sales decline the fixed costs are still to be paid for from this reduced level of
revenues. As a result the operating profit declines.
Illustration: There are two firms A and B manufacturing similar product.
The selling price is $8 per unit. The variable costs of A and B are
respectively $6 and $4. The fixed costs are $20,000 and $80,000
respectively. What is the effect on profit if the sales change from 20,000 to
40,000 units? What happens if the sales decline to 10,000 units?
Solution:

Firm A Firm B

Sales (in units) 10,000 20,000 40,000 10,000 20,000 40,000

Sales Revenue (in $) 80,000 160,000 320,000 80,000 160,000 320,000

Variable Costs (in $) 60,000 120,000 240,000 40,000 80,000 160,000

Contribution (in $) 20,000 40,000 80,000 40,000 80,000 160,000

Fixed Costs (in $) 20,000 20,000 20,000 80,000 80,000 80,000

Profits (in $) 0 20,000 60,000 -40,000 0 80,000

It is clear from the above illustration that an increase in sales with high
operating leverage leads to a greater increase in profits than that of a firm
with lower operating leverage. However, if the sales decline a firm with higher
operating leverage losses more than a firm with lower degree of operating
leverage.

5.4 Degree of Operating Leverage

We have seen that the operating profit of a firm with higher operating leverage
would increase at a faster rate for any given increase in sales. However, if the
sales decline, the firm with a higher operating leverage would suffer more than
a firm with lower operating leverage.
The responsiveness of operating income to change in sales is measured by the
degree of operating leverage (DOL).

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The Degree of operating leverage (DOL) may be defined as the percentage
change in operating income that occurs as a result of a percentage change in
units sold.
DOL = Percentage change in EBIT
Percentage change in sales

DOL = ΔEBIT/EBIT
ΔS/S

Illustration: Table 5-2 shows what happens to profitability as the firm’s

sales go from $160,000 (80,000 units) to $200,000 (100,000 units), i.e.
an increase of 25% in sales.
Table 5.2
Harding Company
Income Statement
For the Year-Ended December 31,2015

Sales - $2 per unit (80,000 units) $160,000 (100,000 units) $200,000

Less: Variable costs ($o.80 per unit) 64,000 80,000
Contribution 96,000 120,000
Less: Fixed costs 60,000 60,000
Operating Income (EBIT) 36,000 60,000
Less: Interest 12,000 12,000
Earnings before taxes 24,000 48,000
Less: Taxes (50%) 12,000 24,000
Earnings after taxes 12,000 24,000
Shares outstanding ÷ 8,000 ÷ 8,000
Earnings per share (EPS) $1.50 $3.00

We will now consider what happen to operating income as volume moves

from 80,000 to 100,000 units. We will compute the degree of operating
leverage using the above formula.
$24,000 𝑥 100
DOL = ΔEBIT/EBIT = $36,000
ΔS/S 20,000 𝑥 100
80,000

DOL = 67% = 2.67 times

25%
Thus, for a 25% increase in output, operating profit will by 67% for Harding
Company. In other words, every 1 % increase in sales volume will be reflected
in a 2.67% increase in operating profits.

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The formula for degree of operating leverage may be algebraically manipulated
to read:
DOL (at the starting point) = Contribution margin = Q (P – VC)
Operating Income Q (P – VC – FC)

Using the newly stated formula FOR Harding Company at Q = 80,000, with P =
$2, VC = $0.80, and FC = $60,000:

DOL = 80.000 ($2.00 - $0.80)

80,000 ($2.00 - $0.80) - $60,000
= 80.000 ($1.20)
80,000 ($1.20) - $60,000
= $96,000
$96,000 - $60,000
= $96,000
$36,000
DOL = 2.67 times
We once again derive an answer of 2.68.

5.5 Degree of Financial Leverage

As was true of operating leverage, degree of financial leverage measures the
effect of a change in one variable on another variable.
Degree of financial leverage (DFL) may be defined as the percentage change
in earnings (EPS) that occurs as a result of a percentage change in earnings
before interest and taxes EBIT).
DFL = Percentage change in EPS
Percentage change in EBIT

DFL = ΔEPS/EPS
ΔEBIT/EBIT

$1.50 𝑥 100
DFL = ΔEPS/EPS = $1.50
ΔEBIT/EBIT 24,000 𝑥 100
36,000

DFL = 100% = 1.50 times

67%
Thus, for a 67% increase in operating income, taxable income as well as
earnings per share will increase by 100% for Harding Company.

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For purposes of computation, the formula for DFL may be conveniently
restated as:
DFL (at the starting point) = Operating Income = Q (P – VC – FC)
Taxable Income Q (P – VC – FC) - I

Let’s compute the degree of financial leverage for Harding Company previously
presented in Table 5-2, at an operating income (EBIT) level of $36,000. The
firm calls for $12,000 of interest at all levels of financing.

DFL = EBIT = $36,000 = $36,000 = 1.5 times

EBIT – I $36,000 - $12,000 $24,000

At an EBIT level of $36,000, a 1 percent increase in operating income will

produce a 1.5 percent increase in taxable income as well as in earnings per
share (EPS).

5.6 Degree of Combined Leverage

Degree of combined leverage (DCL) uses the entire income statement and
shows the impact of a change in sales or volume on bottom-line earnings per
share. Degree of operating leverage and degree of financial leverage are, in fact,
being combined. Table 5-2 shows what happens to profitability as the firm’s
sales go from $160,000 (80,000 units) to $200,000 (100,000 units), i.e.
an increase of 25% in sales.
The formula for degree of combined leverage is stated as:
DCL = Percentage change in EPS
Percentage change in Sales

DCL = ΔEPS/EPS
ΔS/S

Using data from Table 5-2:

$1.50 𝑥 100
DCL = ΔEPS/EPS = $1.50
ΔS/S $40,000 𝑥 100
$160,000

DCL = 100% = 4 times

25%
Every percentage point change in sales will be reflected in a 4 percent change
in earnings per share at this level of operation.

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An algebraic statement of the formula is:
DCL (at the starting point) = Contribution = Q (P – VC)
Taxable Income Q (P – VC – FC) - I

DCL = 80.000 ($2.00 - $0.80)

80,000 ($2.00 - $0.80) - $60,000 - $12,000
= 80.000 ($1.20)
80,000 ($1.20) - $72,000
= $96,000
$96,000 - $72,000

= $96,000
$24,000

DCL = 4 times

(or)

The degree of combined leverage (DCL) may be measured by using the following
formula:

DCL = DOL X DFL

DCL = (% change in EBIT) x (% change in IBT)
(% change in Sales) x (% change in EBIT)
= 2.67 X 1.50
= 4 times

The answer is once again shown to be 4.

You may note that a number of combinations of DOL and DFL may produce
the same DCL and if management has a target for DCL, changes in DOL and
DFL may be made to attain the targeted DCL for instance, if the firm has a high
degree of operating leverage due to the nature of its operations, the degree of
financial leverage may be suitably lowered so as not to lower the targeted
combined leverage and vice-versa.
ENDS