MEANING OF OPERATING AND FINANCIAL LEVERAGE

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 cost-volume-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 DifferencesOperating LeverageFinancial Leverage

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

2.RelationshipOperating leverage lies in the cost structure of the firm

Financial leverage lies in the financial structure of the firm

3. SourcesThe source of operating leverage is fixed cost of the firm like depreciation.

The source of financial leverage is fixed financial charge of the firm like interest

4. ProjectionEffects of Operating leverage is projected on EBIT

Effects of Financial leverage isprojected on EPS

5. CalculationOperating leverage is calculated as:

Percentage change in EBIT

Percentage change in sales

Financial leverage is calculated as:

Percentage change in EPS

Percentage change in EBIT

6. AvoidabilityOperating leverage can not be avoided as fixed cost is a must.

Financial leverage can be avoided by not incorporating any debt.

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

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

8. Creation of riskOperating leverage creates business risk.

Financial leverage creates financial risk.

9. Favourable If sale exceeds BEP or, Sales price rises or, variable cost decreases

If cost of borrowed is less than the cost of equity

10.Justification of useUse of OL is justified if there is a possibility to increase sales.Use of Financial leverage is justified if there is a possibility to increase EPS

11. BenefitAalysis of OL gives management a good deal of information about the operating risk of the companyAalysis of FL helps evaluate various financing plan of the company.

PROBLEM ON LEVERAGE

Balance Sheet of Harding Co as on 31st December 2005ParticularsAmountParticularsAmount

Current AssetsNet Fixed AssetsTotal Assets3,00,0005,00,0008,00,000Debt Capital (10%)Common StockTotal Capital2,00,0006,00,0008,00,000

Other informationParticularsTaka

Sales of Tooth Brush 20000 units@ tk. 20 each)

Less: Variable cost @ tk. 10 p.u. Fixed cost (operating)

taxes (40%)

4,00,000 2,00,000

80,000

Number of shares outstanding is 6000

company compute the following:i. Degree of operating leverage, Degree of financial leverage and Degree of total leverageii. 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 Units20,000 Units30,000 Units (50% increase)

Sales of Tooth Brush 20000 units@ tk. 20 each)

Less: Variable cost @ tk. 10 p.u.

tk. 4,00,000

tk. 2,00,000tk. 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. 20,000tk. 2,20,000

tk. 20,000

Earning before taxes (EBT)

Less: taxes (40%)tk. 1,00,000

tk. 40,000tk. 2,00,000

tk. 80,000

Earning after tax (EAT)tk. 60,000tk, 1,20,000

Earning Per Sharetk. 10tk. 20

Percentage Change in EBIT

= 83.33%

Percentage Change in EPS

= 100%

Percentage Change in Sales 50%

Degree of Operating Leverage

=1.67 times

= 1.67 times

Degree of Financial Leverage

=1.2 times

= 1.2 times

Degree of Total LeverageDOL X DFL

1.67 X 1.2 = 2 times

= 2 times

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