LESSON LEVERAGE ANALYSIS 21.0 AIMS AND OBJECTIVES 21.1 INTRODUCTION 21.2 OPERATING LEVERAGE CONTENTS

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1 LESSON 21 LEVERAGE ANALYSIS CONTENTS 21.0 Aims and Objectives 21.1 Introduction 21.2 Operating Leverage 21.3 Financia Leverage 21.4 EBIT-EPS Anaysis 21.5 Combined Leverage 21.6 Let us Sum up 21.7 Lesson-end Activity 21.8 Keywords 21.9 Questions for Discussion Suggested Readings 21.0 AIMS AND OBJECTIVES The main objective of this esson is to discuss about operation and financia everages and their impact. After studying this esson you wi be abe to: (i) describe the concept of operating everage and cacuate the degree of operating everage (ii) expain various aspects of financia everage (iii) describe EBIT-EPS anaysis to study the impact of the everage 21.1 INTRODUCTION Leverage means the fixed commitment of the organization. The fixed commitment of the organization can be cassified into two different categories viz fixed cost of operations and fixed cost of servicing. The fixed cost of operations are pertaining to the investment decisions and the fixed cost of servicing with reference to the financing decision. Fixed cost of operations Investment decisions. Fixed cost of servicing Financing decisions. If Revenues are more than the Variabe Cost and Fixed Cost, that is caed favorabe or otherwise unfavorabe OPERATING LEVERAGE Operating Leverage is connected with the acquisition of assets where as the financia Leverage is connected with the Financing of activities.

2 Accounting and Finance for Managers Operating everage: It is a reationship in between the Saes and Earnings before interest and taxes. Financia everage: It is a reationship in between the Earnings before interest and taxes and Earnings per share. Operating and Financia: In the Operating and Financia everages, the EBIT is found as a common phenomenon. During the first part of the chapter, et us discuss about the operating everage. It emerges ony due to Fixed operating expenses. By and arge, the expenses are cassified into two categories viz Fixed and Variabe in categories for the anaysis of everage. Operating Leverage is defined as the abiity to use fixed operating costs to magnify the effects of changes in saes on its earnings before interest and taxes. Described as % change in profits accompanying the % change in voume. "The firms' abiity to use fixed operating costs to magnify the effects of changes in the saes on its earnings before interest and taxes". A firms ses products for Rs 100 per unit has variabe operating costs of Rs. 50 per unit and fixed operating cost of Rs. 50,000 per year. Show the various eves of EBIT that woud resut from sae of i) 1000 units ii) 2000 units iii) 3000 units. From the above iustration, it is obviousy understood that from the two different cases. Case A iustrates that 50% increase in the voume of saes ed to 100% increase in the voume of profit. Case B highights that 50% reduction in the voume of saes ed to 100% decrease in the voume of profit. It is ceary evidenced that % change in the voume of saes is ess than the % change in the voume of profit. The next step is to define the Degree of Operating Leverage (DOL) DOL is the measure reveas the extent or degree of operating everage. When Operating everage exists? Proportionate change in EBIT of a given change in saes is greater than the Proportionate in saes Percentage change in EBIT DOL = > 1 Percentage change in Saes Case A= 100%/50%= =+2 Case B=( 100%)/( 50%)=+2 Case B Base Case A Leve from the base 50% +50% Saes in units 1,000 2,000 3,000 Saes voume in Rs 1,00,000 2,00,000 3,00,000 Variabe cost 50,000 1,00,000 1,50,000 Contribution 50,000 1,00,000 1,50,000 Fixed cost 50,000 50,000 50,000 Profit Zero 50,000 1,00, % +100% 292

3 By agebraicay proven and the foowing formua has derived to determine the DOL through the aternate methodoogy Leverage Anaysis Tota Contribution (Base Leve) DOL = EBIT ( Base Leve) To determine the degree of the operating everage, from the above iustration which is appied DOL= Rs.1,00,000/Rs.50,000= +2 The answer of the DOL has been checked in both directions to the direct methodoogy. If there is no fixed operating cost in the manufacturing enterprise? What woud be the Degree of Operating everage? Particuars Base Leve New Leve Units sod 1,000 1,100 Saes price per unit Rs.10 Rs.10 Variabe cost per unit 6 6 Fixed operating cost Ni Ni Cacuate the Degree of operating everage DOL = Tota contribution EBIT To find out the EBIT = Saes -VC=Contribution i.e. EBIT R400 DOL = = +1 Rs.400 In the aternate methodoogy, the DOL is as foows: % change in EBIT 10% DOL = = = +1 % change in Saes 10 When there is no fixed cost in the cost of operations means that the firm does not have operating everage in its operations. The operating everage is reated to the operating risk of the investments, which means that fixed cost of operations of the enterprise. It highights that greater the fixed cost of operations means that higher the operating risk; which means that greater wi be break even point and vice versa. The greater voume of fixed cost of operations are found to be more favorabe ony during the occasion of greater voume of earnings, uness otherwise the dominance of fixed cost of operations are found to be undesirabe to magnify the voume of EBIT FINANCIAL LEVERAGE The next everage is Financia Leverage which arises due to servicing of financia resources. It resuts from the presence of fixed financia charges in the firms. The fixed financia charges are nothing but the preference dividend and interest on the fixed charge financia resources. Financia everage, how the fixed charge financia resources infuence the EBIT of the firm and finay provides earnings to the sharehoders. It reveas the abiity 293

4 Accounting and Finance for Managers of the firm to make use of "fixed financia charges to magnify the effects of changes in EBIT on the earnings per share". The other name of the financia everage is Trading on Equity, which iustrates the reationship in between the appication of the fixed charge of funds in the capita structure and Earning per share. It is the everage anaysis highights the reationship in between the financing decision and investment decision. The fixed financia charge shoud pave way for the firm to not ony to earn the greater EBIT but aso to magnify the EPS of the sharehoders. The financia manager of the hypothetica td expects that its earnings before interest and taxes (EBIT) in the current year woud amount to Rs.10,000. The firm has 5 percent bonds aggregating Rs.40,000 whie the 10 percent preference shares amount to Rs. 20,000 what shoud be the earnings per share (EPS)? Assuming the EBIT being i) Rs.6,000 Rs.14,000. How EPS is affected? The firm tax bracket 35%. Ordinary number of shares 1,000 Case 2 Base Case 1 Leve from the base 40% +40% EBIT 6,000 10,000 14,000 Interest 2,000 2,000 2,000 Earnings Before Interest 4,000 8,000 12,000 Taxes 35% 1,400 2,800 4,200 EAT 2,600 5,200 7,800 Preference dividend 2,000 2,000 2,000 Earnings to share hoders 600 3,200 5,800 EPS Leve 81.25% 81.25% From the above iustration, 40% increase in the eve of EBIT posed 81.25% increase in the EPS and vice versa. Financia everage can be quantified through the Degree of Financia Leverage (DFL) The degree of financia everage is defined as the ratio of % change in the EPS and % change in the EBIT. Which aways greater than 1. The degree of financia everage is more than one due to presence of fixed charge of financia resources. This profound reationship is agebraicay proven and iustrated that EBIT DFL (Base) = EBIT I Dp/1 t DFL of the above firm is as foows: % change in EPS 81.25% DFL = = = % Change in EBIT 40% Aternatey, the DFL is computed as foows through the foowing methodoogy Rs. 10,000 DFL = Rs10,000 Rs.2,000 Rs.2,000/.65 = The same exampe drawn for our better understanding by excuding the fixed charge of financia resources 294

5 Case B Case A Leve of Change 40% + 40% Leverage Anaysis EBIT 6,000 10,000 14,000 Taxes 35% 2,100 3,500 4,900 EAT 3,900 6,500 9,100 Earnings to share hoders 3,900 6,500 9,100 EPS Degree of financia everage = % change in EPS % Change in EBIT + 40% Case A = = % 40% Case B = = % Aternatey, the DFL coud be found out as foows: Rs.10,000 = = +1 Rs.10, It means that the higher Degree of financia everage means that greater the financia risk of the firm and vice versa. The greater degree of financia everage is favorabe ony during the greater voume of EBIT to meet the fixed charges uness otherwise, the firm is required to undergo for iquidation. The interest of the firm may be brought under the contro of the debenture hoders and preference sharehoders EBIT-EPS ANALYSIS It is an anaysis to study the impact /effect of the everage. This coud be studied through comparison of various financing pans of EBIT. (i) Excusive use of debt (ii) Excusive use of Equity shares (iii) Excusive use of Preference shares (iv) Combination of (i), (ii) & (iii) (v) Combination of (i) & (ii) (vi) Combination of (ii) & (iii) (vii) Combination of (i) & (iii) Among the various pans, we have to identify the best pan which has highest EPS over the others. The firm which has highest EPS normay has east voume of fixed financia charge over the other firms. What is meant by financia break even point? It is the eve of EBIT to meet the fixed financia charge of the firm viz Interest on ong term borrowings/debentures and Preference dividend on Preference shares. The foowing formua is used to compute the financia break even point for the firm to earn at east to cover the fixed financia charges of the firm: 295

6 Accounting and Finance for Managers Financia break even point= I + PD/1 t The next anaysis is nothing but Indifference point. Indifference Point: It is the point at which the EPS and EBIT are nothing but the same for two different financing pans known as the indifference point. The indifference point coud be found out through the foowing anayses: (i) Agebraic approach (ii) Graphic approach The measures of the Financia everage: They are two in categories: (i) Stock terms (ii) Fow terms Stock Terms: The foowing are the two ratios viz debt equity ratio and debt + preference share capita to tota capitaization ratio to measure the financia everage. Fow terms: The financia everage means debt service ration and preference dividend coverage ratio to measure the capacity of the firm in meeting the periodica fixed financia commitments of the firm COMBINED LEVERAGE It is the combination of both everage viz Operating everage and financia everage. The combination means that the product of both everages viz operating risk and financia risk, which faciitates to determine the tota risk of the firm. DCL= DOL XDFL % change in EPS DCL = % change in Saes The combined everage is nothing but % change in the saes voume of the firm eads to certain % change in the EPS. DCL = Contribution/EBIT I Check Your Progress 1. Eucidate the Degree of Financia everage. 2. Expain the detaied process of EBIT-EPS anaysis LET US SUM UP 296 Leverage means the fixed commitment of the organization. The fixed commitment of the organization can be cassified into two different categories viz fixed cost of operations and fixed cost of servicing. Operating everage is a reationship in between the Saes and Earnings before interest and taxes. Financia everage is a reationship in between the Earnings before interest and taxes and Earnings per share. The operating everage is reated to the operating risk of the investments, which means that fixed cost of operations of the enterprise. It highights that greater the fixed cost of operations means that higher the operating risk; which means that greater wi be break even point and vice versa.

7 The greater voume of fixed cost of operations are found to be more favorabe ony during the occasion of greater voume of earnings, uness otherwise the dominance of fixed cost of operations are found to be undesirabe to magnify the voume of EBIT. The other name of the financia everage is Trading on Equity, which iustrates the reationship in between the appication of the fixed charge of funds in the capita structure and Earning per share. It is the everage anaysis highights the reationship in between the financing decision and investment decision. EBIT-EPS anaysis is an anaysis to study the impact /effect of the everage. Leverage Anaysis 21.7 LESSON-END ACTIVITY Discuss the roe of EBIT-EPS anaysis in studying the effect of everage KEYWORDS Leverage: Fixed commitments of the firm Operating everage: It is a measure in the expression of business risk through quantification of fixed cost Financia everage: It is an expression of financia risk due to the presence of fixed financia commitment of the firm Combined everage: Combination of both everages i.e. Product of Operating and Financia everages Financia break even point: It is a eve of EBIT to cover the fixed financia commitment of the firm Indifference point: It is the point at which the EBIT and EPS eve of the two different financing pans are nothing but the same QUESTIONS FOR DISCUSSION 1. What is everage? 2. Cassify the type of everages. 3. Define operating everage. 4. Expain the Degree of operating everage. 5. Define the financia everage. 6. Describe the combined everage. 7. Define Indifference point. 8. Define Financia break even point SUGGESTED READINGS R.L. Gupta and Radhaswamy, Advanced Accountancy. V.K. Goya, Financia Accounting, Exce Books, New Dehi. Khan and Jain, Management Accounting. S.N. Maheswari, Management Accounting. S. Bhat, Financia Management, Exce Books, New Dehi. Prasanna Chandra, Financia Management Theory and Practice, Tata McGraw Hi, New Dehi (1994). I.M. Pandey, Financia Management, Vikas Pubishing, New Dehi. Nitin Bawani, Accounting & Finance for Managers, Exce Books, New Dehi. 297

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