Learning
Outcomes
After this Lecture, you will be able to:
• understand concept of Leverage.
• Explain the concept of Operating Leverage.
• Discuss Degree of Operating Leverage.
Leverage
• Refers to accomplishing certain things
which are otherwise not possible i.e. lifting
of heavy objects with the help of lever.
• Its is a tool which makes our task easier,
which produces greater output with lesser
efforts.
Leverage
Effort Load
Fulcrum
Leverage in Finance
The employment of an asset or source
of funds for which the firm has to pay
a fixed cost or fixed return may be
termed as leverage.
Leverage
There are two main types of leverage:
Based on Cost Structure: Operating
Leverage
Capital Structure: Financial Leverage
Types of Leverage
Leverage
Operating Financial Combined
Leverage Leverage Leverage
Types of Leverage
Operating leverage:
• Relationship between the firm’s sales
revenues and its EBIT.
Financial leverage:
• Relationship between the firm’s earnings
available for ordinary shareholders and its
EBIT.
Operating Leverage
The operating costs of a firm fall into Two
categories:
i. Fixed costs: Which do not vary with sales
volume.
ii.Variable costs: which vary directly with the
sales volume.
High Fixed Cost = High Operating Leverage
Operating Leverage
HIGH OPERATING LEVERAGE COMPANY
AIRLINES
Fixed Costs:
• Aircrafts, Hangars, Insurance
Variable Costs:
• Jet Fuel, Runway Charges
Operating Leverage
LOW OPERATING LEVERAGE COMPANY
CONSULTING
Fixed Costs:
• Rent, Utilities
Variable Costs:
• Salaries
Effect of Operating Leverage
• Change in the volume of sales results in a more
than proportional change in operating profit.
•A company with higher operating leverage
generates bigger profits when sales goes up
because fixed costs remain the same as
revenues increase.
• A company with higher operating leverage will
experience bigger losses when sales drop.
• Operating Leverage affects Firm’s business risk.
INCOME STATEMENT
Particular Rs.
Sales (Revenue) ********
Less: Variable Cost ( like raw materials) ********
Contribution ********
Less: Fixed operating cost (like machinery) ********
EBIT ( Earning Before Interest and Taxes) ********
Less: Interest (Financial Charges) ********
EBT ( Earning Before Tax) ********
Less: Tax ********
EAT ( Earning After Tax) ********
Less: Preference Dividend (if any) ********
Earnings available to equity shareholder(A) ********
No. Of Equity Shares(B) ********
EPS ( Earning per Share) = A/B ********
Example
• Firm ABC sells products for Rs 100 per unit
• It has variable operating costs of Rs 50 per
unit and fixed operating costs of Rs 50,000
per year.
• Calculate EBIT from the sale of:
i. 1,000 units
ii. 2,000 units
iii. 3,000 units.
Example
Case 1 Case 2 Case 3
Sales (Units) 1,000 2,000 3,000
Sales Revenue 1,00,0 200,00 3,00,00
00 0 0
Less: Variable Operating 50,000 1,00,0 150,00
Cost 00 0
Contribution 50,000 1,00,0 150,00
00 0
Less: Fixed operating 50,000 50,000 50,000
cost
EBIT 0 50,000 1,00,00
0
Degree of Operating Leverage (DOL)
• The percentage change in a firm’s
operating profit (EBIT) resulting from a per
cent change in output (sales).
Degree of Operating Leverage (DOL)
Also,
Contribution = EBIT + Fixed Cost
Example
Firm X’s
1. Sales = 200
2. Variable cost = 40
3. Fixed Cost = 80
Calculate Degree of Operating Leverage if
sales:
4. Increases by 20% in year 2.
5. Decreases by 20% in year 2.
Example
Increases by 20% in year 2
Year Year Change
1 2 %
Sales 200 240 20%
Variable Cost 40 48 20%
Contribution 160 192 20%
Fixed Cost 80 80 0%
EBIT 80 112 40%
Example
DOL =
% Change in EBIT
% Change in
Sales
=
40%
20%
= 2
Example
• Decreases by 20% in year 2
Year Year Change
1 2 %
Sales 200 160 -20%
Variable Cost 40 32 -20%
Contribution 160 128 -20%
Fixed Cost 80 80 0%
EBIT 80 48 -40%
Example
% Change in
DOL = EBIT
% Change in
Sales
-40%
=
-20%
= 2
Practical problem
• A company has sales of Rs. 5,00,000,
variable cost of Rs 3,00,000, fixed cost of
Rs. 1,00,000 and long term loans of Rs.
4,00,000 at 10% rate of interest. Calculate
the degree of operating leverage.
Practical problem
The following are the details
Selling Price Per Unit Rs. 20
Variable Cost per unit Rs. 12
Actual Sales 100 units
Fixed cost Rs. 1000
Calculate degree of operating leverage when sales
will be
(a) 150 units
(b) 250 units
(c) 300 units
Applications of Operating Leverage
The operating leverage indicates the impact of change in sales on operating
income. If a firm has a high degree of operating leverage, small change in sales
will have large effect on operating income.
A few areas of application are as follows :
(1) Operating leverage has an important role in capital budgeting decisions.
Infact, this concept was originally developed for use in capital budgeting.
(2) Long term profit planning is also possible by looking at quantum of fixed
cost investment and its possible effects.
(3) Generally, a high degree of operating leverage increases the risk of a firm.
For deciding capital structure in favor of debt, the impact of further increase
Conclusion
• Leverage is a two edged sword.
• On one hand it magnifies the profit of the
firm while on the other hand, can also
increase the potential for loss.
• Type of industry and the state of the
economy are two very important factors to
be considered.
Summary
• Concept of leverage.
• Concept of Operating Leverage.
• Calculated Degree of operating leverage.
