WHAT ARE LEVERAGE RATIOS?

The financial ratios that shows the level of debt incurred by a business entity is termed as
leverage ratios. These ratios indicate how the company’s assets and business operations are
financed (using debt or equity).

IMPORTANCE AND USAGE

 It shows how a business is utilizing borrowed money.
 It explains company solvency and capital structure. Having high leverage in a firm’s capital
structure can be risky as well as beneficial.
 The use of leverage is beneficial when the firm is earning profits. On the other hand, a highly
levered firm will have trouble if its profitability declines and will be at a higher risk of
default.
 Calculating the existing level of debt is considered by creditors when a firm wishes to apply
for further borrowing.
 Leverage adds risk but it can also create reward if things go well.

WHAT ARE THE VARIOUS TYPES OF LEVERAGE?

 Operating leverage
An operating leverage ratio explains the ratio of fixed costs to variable costs. Company with
higher operating leverage are said to have large proportion of fixed costs in its operations and is
a capital intensive firm. Small changes in sales volume results in huge changes in earnings and
ROI. When the ratio of fixed costs to revenue is high (>50%) the company has a high operating
leverage.
When the ratio of fixed costs to revenue is low (<20%) the company has less operating leverage.
 Financial leverage

A financial leverage ratio refers to the amount debt a company has been or will have to finance
its business operations. Using borrowed funds, instead of equity funds, can really improve the
company’s return on equity and earnings per share if the increase in earnings is greater than the
interest paid on the loans. But excessive use of financing can lead to default and bankruptcy as
well.
 Combined leverage

A combined leverage ratio refers to the combination of using operating leverage and financial
leverage. For example, when viewing the balance sheet and income statement, operating
leverage influences the upper half of the income statement through operating income while the
lower half consists of financial leverage, wherein earnings per share to the stockholders can be
assessed.
THE VARIABLE AND FIXED COSTS INCURRED BY MAHINDRA & MAHINDRA

Expenses March'17 March'16 March'15 March'14 March'13

Employee Benefit Expenses 2,595.37 2,342.15 2,316.93 2,163.72 1,866.45
Finance cost 145.58 155.29 214.3 259.22 191.19
Depreciation And Amortisation
1,327.16 1,108.61 974.9 863.34 710.81
Expenses

Total Fixed Cost 4,068.11 3,606.05 3,506.13 3,286.28 2,768.45

Cost Of Materials Consumed 20,913.11 19,373.16 20,272.48 21,630.08 20,749.87

Purchase Of Stock-In Trade 10,893.63 10,409.26 7,359.37 8,076.92 9,752.68
Changes in inventory -4.01 -215.8 323.63 -274.67 -78.03
Other expense 4,755.04 4,485.26 4,099.98 4,294.28 3,533.29

Total Variable Cost 36,557.77 34,051.88 32,055.46 33,726.61 33,957.81

Total Cost 40,625.88 37,657.93 35,561.59 37,012.89 36,726.26

CALCULATING THE LEVERAGE RATIOS

Expenses/Year March'17 March'16 March'15 March'14 March'13

Sales 43,116.45 40,884.98 38,444.83 39,963.36 39,903.12

Total Variable Cost 36,557.77 34,051.88 32,055.46 33,726.61 33,957.81

Contribution 6,558.68 6,833.10 6,389.37 6,236.75 5,945.31
Total Fixed Cost 4,068.11 3,606.05 3,506.13 3,286.28 2,768.45
EBIT 2,490.57 3,227.05 2,883.24 2,950.47 3,176.86
Interest 81.59 108.11 156.59 191.42 131.34
PBT 2,408.98 3,118.94 2,726.65 2,759.05 3,045.52
TAX 1,231.85 1,062.42 847.78 611.08 1,094.27

PAT 1,177.13 2,056.52 1,878.87 2,147.97 1,951.25

Operational leverage 2.633405204 2.117444725 2.216038207 2.113815765 1.871442242

Financial Leverage 1.033869106 1.034662417 1.057429446 1.069378953 1.04312564
Total Leverage 2.722596286 2.190840478 2.343304054 2.260470089 1.952149387
Where,
Contribution= Sales- Total variable cost
EBIT= Contribution- total fixed cost
PBT= EBIT-Interest
Operational leverage = Contribution/EBIT
Financial leverage= EBIT/PBT
Total leverage= Operational leverage x financial leverage = Contribution/PBT

INFERENCE
The operational leverage ratio from 2014 to 2017 seems to lie between 2 and 3. It has increased
from 1.87 in 2013.
The Financial leverage ratio remains almost constant and ranges from 1.03 to 1.07.
Hence the total leverage ratios comes to be in a range of 1.9 to 2.8 from 2013 to 2017.
The above depicts a stable leverage ratio for the firm and provides more opportunities for growth
as well.