Leverage Business Risks & Financial Risks Paper 2: Financial Management Unit 3 of Chapter 4 Navin Khandelwal FCA, DISA 1
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LeverageBusinessRisks&FinancialRisks
Paper2:FinancialManagementUnit3ofChapter4
Navin Khandelwal FCA, DISA1
Synopsis Concept of Leverages. Definition. Types of leverages. Operating Leverage. Importance of Operating Leverage.
Financial leverage. Importance of Financial Leverage.
Combined Leverage Graded Illustrations from past CA Exams Pr
epared
By : CA Naveen
Khande
lwal
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LeverageAn Intro.
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ConceptofLeverageLeverage refers to –Relationship between two inter related variables.
It represents ‐The influence of one financial variable over some other related financial variable.
DEFINITION ;% change in one variable divided by the % change in some other variable.
= % change in dependent variable% change in independent variable
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LeverageTypesAn Intro.
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LeverageTypes
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TypesTypes
OperatingOperating FinancialFinancial CombinedCombined
OperatingLeverage(OL)An Intro.
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Definition
The firm’s position or ability to magnify the effect of change in sales over the level of Earnings Before Interest and Tax (EBIT)
OR
Employment of an asset with a fixed cost in the hope that sufficient revenue will be generated to cover all the Fixed and Variable costs.
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Relationship
Measures the relationship between the sales revenue and EBIT.
OL = C / EBIT
OL = % change in EBIT % change in Sales Revenue
EBIT = Earning before interest and taxes or :( Contribution ‐ Fixed Costs)
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GreaterBusinessRiskwithGreaterOperatingLeverageHigher Operating Leverage leads to more Business Risk
A Small Sales decline causes a larger Profit decline
As in our example we see % inc in Sales is 10% % inc in EBIT is 12.5% So our OL is 1.25 Now if we assume that our OL is higher Say 4Then 10% Change in Sales can cause 40% (4 x 10 )change in EBIT i.e. increase & decrease in both ways
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ImportanceofOL
A firm should always try to avoid operating under high DOL..Under good economic condition a high OL are favorable for thefirm but under bad economic condition a high OL is notpreferred for the firm.
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OperatingLeverageIllustration 1
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Illustration1(A)‐Shahrukh Khan Ltd. has the following details related to Sales, Variable Cost & Fixed Costs. Calculation of EBIT & OL has been Shown below.
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Particular Amount (Previous year)
Amount (Current year)
Change/Difference
Change in %
Sales 10,00,000 11,00,000 1,00,000 10%
Variable Cost 5,00,000 5,50,000 50,000 10%
Contribution 5,00,000 5,50,000
Fixed Cost 1,00,000 1,00,000 0 0
EBIT 4,00,000 4,50,000 50,000 12.5%
OL =12.5%/10%=1.25
Illustration1(B)‐Shahrukh Khan Ltd. has the following details related to Sales, Variable Cost & Fixed Costs. Calculation of EBIT & OL has been Shown below.
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Particular Amount (Previous year)
Sales 10,00,000
Variable Cost 5,00,000
Contribution 5,00,000
Fixed Cost 1,00,000
EBIT 4,00,000
OL =5,00,000/4,00,000=1.25
FinancialLeverage(FL)An Intro.
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FLmeans...
•Use of funds with a fixed cost in order to increaseEPS (earning per share).
•Use of companies funds in which it pays a limitedreturn.
•Use of fixed cost funds in such a way to increase thereturn on shareholders funds.
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Definition‐ FL
FL = % change in EPS
% change in EBIT
The existence of fixed financing charge is instrumental tobring this magnifying effect and also determines the extentof this effect. Pr
epared
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CalculationofFinancialLeverage
FL = EBIT / EBTor
FL = EBIT / EBIT-I-PD/(1-T)Where : FL = Financial leverageEBIT =Earning before interest and taxesEBT = Earning before taxes = EBIT – INTEREST PD=Preference DividendT=Tax Rate
FinancialLeverageIllustration 2
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Illustration2(A)‐Salman Khan Ltd. has the following details related to Sales, Variable Cost & Fixed Costs. Calculation of EBIT, EPS & FL has been Shown below.
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Particular Amount (Previous year)
Amount (Current
year)
Change/Difference
Change in %
Sales 10,00,000 11,00,000 1,00,000 10%
Variable Cost 5,00,000 5,50,000 50,000 10%
Fixed Cost 1,00,000 1,00,000 0 0
EBIT 4,00,000 4,50,000 50,000 12.5%
EPS 10 12 2 20%
FL =20%/12.5%=1.6
Illustration2(B)‐Salman Khan Ltd. has the following details related to Sales, Variable Cost & Fixed Costs. Calculation of EBIT, EBT & FL has been Shown below.
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Particular Amount (Previous year)
Sales 10,00,000
Variable Cost 5,00,000
Fixed Cost 1,00,000
EBIT 4,00,000
Interest 2,00,000
EBT 2,00,000
FL =4,00,000/2,00,000=2
ImportanceofFinancialLeverage
• Higher the level of fixed financial charge, greater would be theFL.
• The changes in EPS would be at a higher rate than thechanges in EBIT.
• The advantage arises from the possibility that funds borrowedat a fixed interest rate can be used for investmentopportunities earning a rate of return higher than the interestpaid. Pr
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CombinedLeverage(CL)An Intro.
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Definition&Formula• Potential use of fixed costs, both operating and
financial, which magnifies the effect of sales volume on the earning per share of the firm
= % Change inEPS% Change in sales
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CombinedLeverage
• OL explains the business risk complexion.
• FL explains the financial risk of the firm.
• CL explains the overall risk of the firm.
• Thus , CL = OL X FL
CL = Cont / EBT
CombinedLeverageIllustration 3
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Illustration3‐Amir Khan Ltd. Has Following OL & FL . We can Calculate the Combined Leverage for it as follows
OL= 1.25
FL= 0.5
CL= 1.25 x 0.5 = 0.625
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PastExaminationProblemsonLeverages
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Illustration4
Operating, Financial & Combined Leverage
CA PE‐II, Nov 2002
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ProblemStatement
The data relating to two companies are as given below :Particulars Company A Company BCapital 6,00,000 3,50,000Debentures 4,00,000 6,50,000Output (Units) Per Annum 60,000 15,000Selling Price/ Unit 30 250Fixed Cost Per Annum 7,00,000 14,00,000Variable Cost / Unit 10 75You are required to calculate the Operating leverage , Financial Leverage , Combined Leverage of two Companies. (Ans ;DOL 2.4,2.14 , DFL 1.11 , 1.07 , DCL 2.66 , 2.29 )
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Illustration5
Operating, Financial & Combined Leverage
CA (Nov – 2004)
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ProblemStatementThe following summarizes the % changes in operating income,% changes in revenues for pharmaceutical firms.
Change in Revenue Change in Operating IncPQR Ltd 27% 25%RST Ltd 25% 32%TUV Ltd 23% 36%WXY Ltd 21% 40%Required :Calculate the degree of Operating Leverage for each of these firms.Comment also.
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Illustration6
Operating, Financial & Combined Leverage
CA (May – 2008)
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ProblemStatementThe following data relate to RT Ltd :
RsEarning before interest and tax (EBIT) 10,00,000Fixed cost 20,00,000Earning Before Tax(EBT) 8,00,000Required :Calculate Combined Leverage.
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Illustration7
Operating, Financial & Combined Leverage
CA (Nov – 2009)
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ProblemStatementFrom the following Financial data of Company A and Company B. Prepare their Income Statements.
Company A Company BVariable cost 56,000 60% of salesFixed cost 20,000 ‐Interest expenses 12,000 9,000Financial Leverage 5:1 ‐Operating Leverage ‐ 4:1Income tax rate 30% 30%Sales ‐ 1,05,000
(Ans : EAT A – 2100, B‐ 1050)
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Illustration7
Operating, Financial & Combined Leverage
CA (Nov – 2008)
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ProblemStatementA Company operates at a production level of 1,000 units. Thecontribution is Rs 60 per unit, operating leverage is 6, combinedleverage is 24. If tax rate is 30% , what would be its earningsafter tax ?
(Ans : Rs 1750)
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Illustration8
Operating, Financial & Combined Leverage
CA (Nov – 2007)
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ProblemStatementAnswer the following :A firm has Sales of Rs 40 lakhs ; Variable cost of Rs 25 lakhs ;Fixed cost of Rs 6 lakhs ; 10% debts of Rs 30 lakh ; and EquityCapital of Rs 45 lakhs.
Required :Calculate operating and financial leverage.
(Ans : OL 1.67, FL 1.50)
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ThankYou
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