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MEANING OF OPERATING AND FINANCIAL LEVERAGE

Operating leverage occurs any time a firm has fixed cost that must be met regardless of
volume. operating leverage is the technique of magnifying the EBIT by using fixed costs
that must be met regardless of volume in the capital structure. An entrepreneur generally
employ assets with a fixed cost in the hope that volume will produce revenues more than
sufficient to cover all fixed and variable costs. For example in an airline industry, a large
portion of total cost are fixed. B1eyond the break-even point each additional passenger
represents essentially straight profit to the airline. So is the case of a bus or railway and so
on. With fixed costs, the percentage change in profit accompanying a change in volume is
greater than the percentage change in volume. This occurace is known as operating
leverage. Operating leverage can be explained better by means of break-even or costvolume-profit analysis.
Financial Leverage may be defined as the use of fixed financial charges in the firms
capital structure to magnify the Earning Per Share. Financial leverage occurs when
funds with charges, such as debt and preference share are used with the owners
equity in the capital structure. The financial leverage is employed by a company with
an intention to earn more on fixed charges funds than their costs. It amy be compared
to a fulcrum used in physics in the sense that the surplus over interest cost will be
used as a lever or fulcrum to increase the return on the owners equity which is
projected by an increase in the EPS. For example, if a company borrows tk. 100 at
10 per cent interest. This is also termed as trading on the equity in the sense that
here the owners equity is used as a basis to raise debt.

Distinction between Operating Leverage and Financial Leverage


Points of Differences Operating Leverage
1. Definition
Operating Leverage may be defined
as the use of fixed cost in the firms
cost structure to magnify the
Earning Before Interest and Taxes

Financial Leverage
Financial Leverage may be defined
as the use of fixed financial charges
in the firms capital structure to
magnify the Earning Per Share.

2.Relationship

Operating leverage lies in the cost Financial leverage lies in


structure of the firm
financial structure of the firm

the

3. Sources

The source of operating leverage is The source of financial leverage is


fixed cost of the firm like fixed financial charge of the firm
depreciation.
like interest

4. Projection

Effects of Operating leverage is Effects of Financial


projected on EBIT
isprojected on EPS

5. Calculation

Operating leverage is calculated as:


Percentage change in EBIT
Percentage change in sales

6. Avoidability

Operating leverage can not be Financial leverage can be avoided


avoided as fixed cost is a must.
by not incorporating any debt.

7. Existence

Whenever the percentage change in


EBIT resulting from a geven
percentage change in sales is
greater than the % change in sales,
Operating leverage exists.

8. Creation of risk

Operating leverage creates business Financial leverage creates financial


risk.
risk.

9. Favourable

If sale exceeds BEP or, Sales price If cost of borrowed is less than the
rises or, variable cost decreases
cost of equity

leverage

Financial leverage is calculated as:


Percentage change in EPS
Percentage change in EBIT

Whenever the percentage change in


EPS resulting from a geven
percentage change in EBIT is
greater than the % change in EBITs,
Financial leverage exists.

10.Justification of use

Use of OL is justified if there is a Use of Financial leverage is


possibility to increase sales.
justified if there is a possibility to
increase EPS
Aalysis of OL gives management a Aalysis of FL helps evaluate
good deal of information about the various financing plan of the
operating risk of the company
company.

11. Benefit

PROBLEM ON LEVERAGE
Balance Sheet of Harding Co as on 31st December 2005
Particulars
Current Assets
Net Fixed Assets
Total Assets

Amount
3,00,000
5,00,000
8,00,000

Particulars
Debt Capital (10%)
Common Stock
Total Capital

Amount
2,00,000
6,00,000
8,00,000

Other information
Particulars
Sales of Tooth Brush 20000 units@ tk. 20 each)
Less: Variable cost @ tk. 10 p.u.
Fixed cost (operating)
taxes (40%)

Taka
4,00,000
2,00,000
80,000

Number of shares outstanding is 6000


company compute the following:
i.
ii.

Degree of operating leverage, Degree of financial leverage and Degree of total


leverage
You are also required to show the effect of operating leverage on EBIT and the effect
of financial leverage on EPS if the company increases its sale by 50 percent.

SOLUTION:
Sales in Units
Sales of Tooth Brush 20000 units@
tk. 20 each)
Less: Variable cost @ tk. 10 p.u.

20,000 Units
tk. 4,00,000
tk. 2,00,000

30,000 Units (50%


increase)
tk. 6,00,000
tk. 3,00,000

Contribution
Less fixed cost (operating)

tk. 2,00,000
tk 80,000

tk. 3,00,000
tk. 80,000

Earning Before Interest and


Taxes (EBIT)
Less Interest expenses on debt

tk. 1,20,000
tk. 20,000

tk. 2,20,000
tk. 20,000

Earning before taxes (EBT)


Less: taxes (40%)
Earning after tax (EAT)

tk. 1,00,000
tk. 40,000
tk. 60,000
tk. 10

tk. 2,00,000
tk. 80,000
tk, 1,20,000
tk. 20

Earning Per Share


Percentage Change in EBIT

2,20,000 1,20,000 X 100


1,20,000

= 83.33%

20 10 X 100
10

Percentage Change in EPS


Percentage Change in Sales
Degree of Operating Leverage

Degree of Financial Leverage

Degree of Total Leverage

= 100%
50%
CM
EBIT

PercentageChangeinEBIT
Percentagechangeinslaes

2,00,000
=1.67 times
1,20,000

83.33
= 1.67 times
50%

EBIT
EBT

PercentageChangeinEPS
PercentagechangeinEBIT

1,20,000
=1.2 times
1,00,000

100
= 1.2 times
83.33

DOL X DFL
1.67 X 1.2 = 2 times

PercentageChangeinEPS
PercentagechangeinSales

100
= 2 times
50

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