Types of leverages
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Transcript of Types of leverages
TYPES OF LEVERAGES
BYASWATHY JAYAN
LEVERAGE ‘Leverage’ means ‘effectiveness’ or ‘power’A firm is said to be leveraged if it has fixed
costDegree of leverage -Measure of how much leverage the firm
uses There are three types of leverages -Operating leverages -Financial leverages -Combined leverages
Operating leverage Operating leverage is a
measurement of the degree to which a firm incurs a combination of fixed and variable cost
Operating leverage = contribution/EBIT
contribution = sales – variable cost
EBIT = contribution –fixed costNote : in case the contribution exceeds
the fixed cost,the operating leverage is favorable. when C<F, the operating leverages is unfavorable
Degree of operating leverage
It measures how muchis the effect of change in sales on operating profit.
The degree of operating leverage at any level is expressed in percentage change in operating profit to percentage change in sales
Degree of operating leverage= % change in EBIT
% change in sales
Importance of operating leverages
Profit planning Capital structure planning Risk analysis
Financial leverage It is the tendency of the residual net
income to vary disproportionately with the operating profit. It indicate the changes that takes place in the taxable income as a result of the change in the operating profit.
Financial leverage= EBIT EBTEBIT= Earning before interest and taxEBT= I-EBIT , ie earning before taxI = interest and preference divident
Degree of financial leverage The degree of financial leverage is
defined as the percentage change in EPS due to the given percentage change in EBIT.
DFL = % change in EPS % change in EBIT
Limitations of financial leverages
Increases risk Beneficial only to companies having
stable earning Restrictions from financial
institutions
Difference between Operating leverage & Financial Leverage It establishes the
relationship b/w operating profit & sales
It influence EBIT It is concerned with
investment decision It explains business
risk of the firm It is the first stage
leverage
It establishes the relationship b/w operating profit & rate of equity
It affect EAT It is concerned with
finance decision It deals with financial
risk of the firm It is the second stage
leverage
Combined or Total leverage It is the combination of operating
and financial leverage Both of these leverage are closely
concerned with firms capacity to meet its fixed cost & their combined effect will measure the firms financial strength.
Combined leverage = operating leverage *
financial leverage
Degree of combined leverage It is calculated by multiplying the
DOL and the DFL and it is calculated by the formula
Degree of combined leverage =DOL * DFL ie,= % change in EPS % change in sale