Leverages Types
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Leverages
In very simple words, the term leverage measures relationship between two variables. In financial analysis, the term leverage represents the influence of one financial variable over some other financial variable. In financial analysis generally three types of leverages may be computed:
It is computed as:
Sales – variable (i.e. contribution)
Earnings before interest and tax
Indications:
A high degree of operating leverage means that the component of fixed cost is too high in the overall cost structure. A low degree average of operating average means that the component of fixed cost is less than the overall cost structure. In other words, operting leverage measures the impact of percentage increase or decrease in sales oin earnings before interst and taxes.
E.g. In the example cited above when sales are $ 20,000 contribution is $ 10,000 and earnings before interest and tax are $ 5000. As such operating leverage can be calculated as:
Contribution = $ 10000
EBIT = $ 5000
= 2
It means that every 1 % increae in contribution will increase the EBIT by 2% and vice versa. As suh when contribution is $ 9000 instead of $ 10000 i.e. the contribution is reduced by 10% the EBIT is reduced by 20% i.e the EBIT has become $ 4000 instead of $ 5000
EBIT
EBIT – interest
Indications:
A high degree of financial leverage indicates high use of fixed income bearings securitirs in the capital structure of the company. A low degre of finanical leverage indicates less use of fixed income bearing securitires in the capital strucutre of the company.
E.g. the example cited above, in case of A Ltd. The EBIT is $ 5000 and interest on debentures is $ 900 when sales are $ 20000 where as in case of B Ltd. The EBIT is $ 5000 and interest on debentures leverage can be computed as:
EBIT
EBIT – Interest
Financial leverage =
It is computed as:
Operating leverage X Financial leverage
= sales – variable cost)/(EBIT EBIT – interest) X EBIT
= (sales – varibale)/(EBIT – interest)
1. Operating leverage
It measures the effect of change in sales quantity on earnings before interest and taxes (EBIT)It is computed as:
Sales – variable (i.e. contribution)
Earnings before interest and tax
Indications:
A high degree of operating leverage means that the component of fixed cost is too high in the overall cost structure. A low degree average of operating average means that the component of fixed cost is less than the overall cost structure. In other words, operting leverage measures the impact of percentage increase or decrease in sales oin earnings before interst and taxes.
E.g. In the example cited above when sales are $ 20,000 contribution is $ 10,000 and earnings before interest and tax are $ 5000. As such operating leverage can be calculated as:
Contribution = $ 10000
EBIT = $ 5000
= 2
It means that every 1 % increae in contribution will increase the EBIT by 2% and vice versa. As suh when contribution is $ 9000 instead of $ 10000 i.e. the contribution is reduced by 10% the EBIT is reduced by 20% i.e the EBIT has become $ 4000 instead of $ 5000
2. Financial leverage
It indicates the firm’s ability to use fixed financial charges to magnify the effects of changes in EBIT on the firm’s EPS. It indicates the extent to which the earnings per share (EPS) will be affected with the change in earnings before tax (EBIT). It is computed as:EBIT
EBIT – interest
Indications:
A high degree of financial leverage indicates high use of fixed income bearings securitirs in the capital structure of the company. A low degre of finanical leverage indicates less use of fixed income bearing securitires in the capital strucutre of the company.
E.g. the example cited above, in case of A Ltd. The EBIT is $ 5000 and interest on debentures is $ 900 when sales are $ 20000 where as in case of B Ltd. The EBIT is $ 5000 and interest on debentures leverage can be computed as:
EBIT
EBIT – Interest
Financial leverage =
| A Ltd. | B Ltd. |
| $ 5000 | $ 5000 |
| $ 5000 - $ 900 | $ 5000 - $ 100 |
| = $ 5000 | = $ 5000 |
| $ 4100 | $ 4900 |
| = 1.22 | = 1.02 |
3. Combined leverage:
The combined effect of operating leverage and financial leverage measures the impact of charge in contribution on EPS.It is computed as:
Operating leverage X Financial leverage
= sales – variable cost)/(EBIT EBIT – interest) X EBIT
= (sales – varibale)/(EBIT – interest)