Discuss the concept of leverage? Distinguish the operating leverage from financial leverage.

Discuss the concept of leverage? Distinguish the operating leverage from financial leverage.

Ans Financial decision is one of the integral and important parts of financial management in any kind of business concern. A sound financial decision must consider the board coverage of the financial mix (Capital Structure), total amount of capital (capitalization) and cost of capital (K_o). Capital structure is one of the significant things for the management, since it influences the debt equity mix of the business concern, which affects the shareholder’s return and risk. Hence, deciding the debt-equity mix plays a major role in the part of the value of the company and market value of the shares. The debt equity mix of the company can be examined with the help of leverage.

The term leverage refers to an increased means of accomplishing some purpose. Leverage is used to lifting heavy objects, which may not be otherwise possible. In the financial point of view, leverage refers to furnish the ability to use fixed cost assets or funds to increase the return to its shareholders.

James Horne has defined leverage as, “the employment of an asset or fund for which the firm pays a fixed cost or fixed return.

Leverage can be classified into three major headings according to the nature of the finance mix of the company.

The company may use finance or leverage or operating leverage, to increase the EBIT and EPS.

OPERATING LEVERAGE

The leverage associated with investment activities is called as operating leverage. It is caused due to fixed operating expenses in the company. Operating leverage may be defined as the company’s ability to use fixed operating costs to magnify the effects of changes in sales on its earnings before interest and taxes. Operating leverage consists of two important costs viz., fixed cost and variable cost. When the company is said to have a high degree of operating leverage if it employs a great amount of fixed cost and smaller amount of variable cost. Thus, the degree of operating leverage depends upon the amount of various cost structure. Operating leverage can be determined with the help of a break even analysis.

Operating leverage can be calculated with the help of the following formula:

OL = C/OP

Where

OL = Operating Leverage

C = Contribution

OP = Operating Profits

Degree of Operating Leverage

The degree of operating leverage may be defined as percentage change in the profits resulting from a percentage change in the sales. It can be calculated with the help of the following formula:

DOL = Percentage change in profits/ Percentage change in sales

Uses of Operating Leverage

Operating leverage is one of the techniques to measure the impact of changes in sales which lead for change in the profits of the company.

If any change in the sales, it will lead to corresponding changes in profit. Operating leverage helps to identify the position of fixed cost and variable cost.

Operating leverage measures the relationship between the sales and revenue of the company during a particular period.

Operating leverage helps to understand the level of fixed cost which is invested in the operating expenses of business activities.

Operating leverage describes the over all position of the fixed operating cost.

Effect of Operating Leverage on Net Income

The percentage change in net income based on a percentage change in sales equals DOL times the percentage change in sales, times 100. For example, if your small business has a DOL of 7 and a 5 percent increase in sales, multiply 7 times 0.05 times 100 to get a 35 percent increase in net income. If you instead had a lower DOL of 3 and the same sales increase, your net income would rise by just 15 percent, or 3 times 0.05 times 100.

Return on Equity

ROE equals net income divided by stockholders’ equity, times 100. Stockholders’ equity -- which is listed on the balance sheet -- is the value of stockholders’ stake in a business. For example, assume your small business has $10,000 in net income and $50,000 in stockholders’ equity. Divide $10,000 by $50,000, and multiply your result by 100 to get a 20 percent ROE. This means you generate net income equal to 20 percent of stockholders’ equity.

Effect of Operating Leverage on ROE

Because net income is the numerator of the ROE formula, operating leverage has a similar effect on ROE as it does on net income. A higher DOL boosts ROE when sales rise, but it also accelerates the decrease in ROE when sales decline. You can increase your DOL by increasing your fixed costs relative to variable costs, but be aware of the negative effects on ROE when sales decrease.

FINANCIAL LEVERAGE

Leverage activities with financing activities is called financial leverage. Financial leverage represents the relationship between the company’s earnings before interest and taxes (EBIT) or operating profit and the earning available to equity shareholders.

Financial leverage is defined as “the ability of a firm to use fixed financial charges to magnify the effects of changes in EBIT on the earnings per share”. It involves the use of funds obtained at a fixed cost in the hope of increasing the return to the shareholders. “The use of long-term fixed interest bearing debt and preference share capital along with share capital is called financial leverage or trading on equity”.

Financial leverage may be favourable or unfavourable depends upon the use of fixed cost funds.

Favourable financial leverage occurs when the company earns more on the assets purchased with the funds, then the fixed cost of their use. Hence, it is also called as positive financial leverage.

Unfavourable financial leverage occurs when the company does not earn as much as the funds cost. Hence, it is also called as negative financial leverage.

Financial leverage can be calculated with the help of the following formula:

FL =OP/PBT

 Where,

FL = Financial leverage

OP = Operating profit (EBIT)

PBT = Profit before tax.

Degree of Financial Leverage

Degree of financial leverage may be defined as the percentage change in taxable profit as a result of percentage change in earning before interest and tax (EBIT). This can be calculated by the following formula

DFL=Percentage change in taxable income

Percentage change in EBIT

Uses of Financial Leverage

Financial leverage helps to examine the relationship between EBIT and EPS.

Financial leverage measures the percentage of change in taxable income to the percentage change in EBIT.

Financial leverage locates the correct profitable financial decision regarding capital structure of the company.

Financial leverage is one of the important devices which is used to measure the fixed cost proportion with the total capital of the company.

If the firm acquires fixed cost funds at a higher cost, then the earnings from those assets, the earning per share and return on equity capital will decrease.

Impacts of Financial Leverage

Taking on debt, as an individual or a company, will always bring about a heightened level of risk due to the fact that income must be used to pay back the debt even if earnings or cash flows go down. From a company's perspective, the use of financial leverage can positively - or sometimes negatively - impact its return on equity as a consequence of the increased level of risk.

Impact on Return on Equity

Return on equity is the rate of return on the shareholders' equity of a company's common stock owners. It measures a firm's efficiency at generating profits from every unit of shareholders' equity. Return on equity shows how well a company uses investment funds to generate earnings growth. It can be calculated using the following equation:

Return On Equity

The equation used to calculate return on equity.

At an ideal level of financial leverage, a company's return on equity increases because the use of leverage increases stock volatility, increasing its level of risk which in turn increases returns. However, if a company is financially over-leveraged a decrease in return on equity could occur. Financial over-leveraging means incurring a huge debt by borrowing funds at a lower rate of interest and using the excess funds in high risk investments. If the risk of the investment outweighs the expected return, the value of a company's equity could decrease as stockholders believe it to be too risky.

Leverage, Risk, and Misconceptions

The most obvious risk of leverage is that it multiplies losses. Due to financial leverage's effect on solvency, a company that borrows too much money might face bankruptcyduring a business downturn, while a less-levered company may avoid bankruptcy due to higher liquidity. There is a popular prejudice against leverage rooted in the observation of people who borrow a lot of money for personal consumption - for example, heavy use of credit cards. However, in finance the general practice is to borrow money to buy an asset with a higher return than the interest on the debt. Instead of spending money it doesn't have, a company actually creates value. On the other hand, when debt is taken on for personal use there is no value being created, i.e., no leveraging.

There is also a misconception that companies enter a higher level of financial leverage out of desperation, referred to as involuntary leverage. While involuntary leverage is certainly not a good thing, it is typically caused by eroding equity value as opposed to the addition of more debt. Therefore, it is typically a symptom of the problem, not the cause.

When evaluating the riskiness of leverage it is also important to factor in the value of the company itself and its activities. If a company borrows money to modernize, add to its product line, or expand internationally, the additional diversification will likely offset the additional risk from leverage. The upshot is, if value is expected to be added from the use of financial leverage, the added risk should not have a negative effect on a company or its investments.

Key Differences Between Operating Leverage and Financial Leverage

The following are the major differences between operating leverage and financial leverage:

1. Employment of fixed cost bearing assets in the company’s operations is known as Operating Leverage. Employment of fixed financial charges bearing funds in a company’s capital structure is known as Financial Leverage.
2. The Operating Leverage measures the effect of fixed operating costs, whereas Financial Leverage measures the effect of interest expenses.
3. Operating Leverage influences Sales and EBIT but Financial Leverage affects EBIT and EPS.
4. Operating Leverage arises due to the company’s cost structure. Conversely, the capital structure of the company is responsible for Financial Leverage.
5. Low operating leverage is preferred because higher DOL will cause high BEP and low profits. On the other hand, High DFL is best because a slight rise in EBIT will cause a greater rise in shareholder earnings, only when the ROCE is greater than the after-tax cost of debt.
6. Operating Leverage creates business risk while Financial Leverage is the reason for financial risk.

COMBINED LEVERAGE

When the company uses both financial and operating leverage to magnification of any change in sales into a larger relative changes in earning per share. Combined leverage is also called as composite leverage or total leverage.

Combined leverage express the relationship between the revenue in the account of sales and the taxable income.

Combined leverage can be calculated with the help of the following formulas:

CL = OL × FL

C      OP       C

^{CL =} OP ^× PBT ⁼ PBT

Where,

CL = Combined Leverage

OL = Operating Leverage

FL = Financial Leverage

C = Contribution

OP = Operating Profit (EBIT)

PBT = Profit Before Tax

Degree of Combined Leverage

The percentage change in a firm’s earning per share (EPS) results from one percent change in sales. This is also equal to the firm’s degree of operating leverage (DOL) times its degree of financial leverage (DFL) at a particular level of sales.

Degree of contributed coverage

Percentage change in EPS

Percentage change in sale