UNIT VII LEVERAGES

If all the costs of a firm are variable in nature, profits will vary proportionally with sales.
In the real world, however, several costs remain fixed with respect to sales, at least in short run. Therefore total operating expenses do not rise as rapidly as sales revenue. Thus, operating profits rise faster than sales. Moreover, non operating expenses (like interest payments) are also relatively fixed. Hence, net operating profit (after interest charges) rise even faster than operating profits.

These two factors are referred to as operating leverage and financial leverage.
Operating leverage is defined in terms of the relationship between fixed and variable operating expenses. Financial leverage refers to the mix of debt and equity used to finance the firms activity. The degree of leverage is measured in terms of ratio of debt to equity.

Concept of Leverage :
The dictionary meaning of leverage is an increased means for accomplishing some purpose.

In finance, it means the firms ability to use fixed cost assets or funds to magnify the return to its owners.
According to James Van Horne, leverage refers to the employment of an asset or funds for which the firm pays a fixed cost or fixed return. In general, it refers to the relationship between two interrelated variables, like costs, output, sales, EBIT, EPS etc. In financial analysis, leverage reflects the responsiveness or influence of one variable over some other variable. Here numerator is dependent variable and denominator is independent variable. Thus,

Leverage = % change in dependent variable % change in independent variable

Some Relationships :
We know the format of income statement, which is as follows Total Revenue Less : Variable Costs Less : Fixed Operating Costs Earning Before Interest and Tax Less : Interest Profit Before Tax Less : Tax Profit After Tax Less : Preference Dividend Equity Earning

Let us assume
TR = total revenue; P = selling price per unit F = fixed operating cost I = interest T = corporate tax rate Ee = equity earnings EPS = earning per share Q = quantity produced and sold V = variable cost per unit EBIT = operating income PBT = profit before tax DP = preferred dividend N = no. of outstanding equity shares

Given these notations, the different relationship will be

EBIT = TR TVC FOC; OR

EBIT = (QP) (QV) F = Q(P-V) F

PAT = (EBIT I) (1 T)

EPS = Profit after tax Preferred dividend Number of equity shares EPS = (EBIT I) (1 T) - DP N OR, EPS = [Q(P V) F 1] (1 T) DP N These relationships will be used in further discussion.

Functional Relationship between Sales and EPS :

It can be established as Sales Revenue EBIT Less : Variable Cost Less : Interest Contribution Profit before tax Less : Fixed Cost Less : Tax EBIT Profit after tax Less : Preferred dividend Equity earning (/ N) EPS The left hand side, which shows the relationship between SR and EBIT, is defined as operating leverage, and right hand side shows the relationship between EBIT and EPS, is defined as financial leverage.

The direct relationship between sales revenue and EPS can also be established by combining the operating leverage and financial leverage, and is defined as combined / composite leverage.

Operating Leverage :
It is defined as the firms ability to use fixed operating costs to magnify the effects of changes in sales on its EBIT. The operating costs of a firm falls into three categories a) fixed costs which do not vary with sales b) variable costs which vary directly with sales c) semi-variable or semi-fixed costs Higher the operating costs, higher will be the operating leverage.

Degree of Operating Leverage (DOL) :

It measures the sensitivity of operating income (EBIT) to changes in revenues or quantity sold. The DOL is defined as DOL = % change in EBIT % change in SR

EBIT / EBIT DOL ; OR Q / Q Q(P - V) DOL Q(P - V) - F

Application of Operating Leverage : It measures the percentage change in EBIT from a change of one percent in the level of output. It helps in i) understanding EBIT changes ii) measuring business risks iii) higher DOL will pose higher risk to the firm The DOL may, at any particular sales volume, also be calculated as

DOL = Contribution EBIT

A positive DOL means that the firm is operating at level higher than the break-even level and both the EBIT and Sales will move in the same direction, and vice-versa. If DOL is 1, means no OL.

Cost-Volume-Profit (C-V-P) Analysis / Break-Even Analysis : It helps in answering certain questions, like - how do costs behave in relation to volume? - at what sales volume would the firm break-even? - how sensitive is profit to variations in output? - what would be the effect of a projected sales volume on profit? - how much should the firm produce and sell in order to reach a target profit level?

Basic Assumptions :
i) The behaviour of cost is predictable

The cost of the firm is divided into two components fixed cost and variable cost.

If we know these two components, we can predict the cost for a certain range of output, and the range will be called as relevant range. ii) The unit selling price is constant
This implies that the total revenue of the firm is a linear function of output. iii) The firm manufactures a stable product-mix Without this assumption, it is not possible to define the average variable profit ratio, when different products have different variable profit ratios. iv) Inventory charges are nil It means volume of sales are equal to volume of production.

This is required to match the total cost to total revenue, for a particular period.
Profit Equation : The net profit after tax is defined as = [QP QV F I] (1 T) Along with calculating net profit, this equation is used to calculate break-even quantity, profit for a given quantity level, quantity required for a given level of profit, and break-even sales in rupee term. i) Break-even quantity

here net profit will be zero, then the equation will be

FI Q P-V
here (P-V) represents the difference between the unit selling price and the unit variable cost, is called as contribution. ii) Profit for a given quantity in this case, same formula will be used. iii) Quantity for a given profit to find the quantity to attain a certain target profit (t), the formula will be -

/ (1 - T) F I Q P-V
t

iv) Break-even sales in rupees

it is simply

break-even quantity unit selling price

Or the formula will be
Breakeven sales in rupees FI 1 V / P

Multiple Product Analysis : The overall break-even volume of a multi-product firm is given by -

FI
i

W CM
i 1

where Wi = proportion of product i, quantity wise, in the sales mix of the firm ( Wi = 1)
CMi = contribution margin of product i For example suppose a company manufactures three products P, Q and R. The unit selling price of these products are Rs100, Rs80 and Rs50 respectively and the unit variable costs are Rs50, Rs40 and Rs20 respectively. The proportions in which these products are manufactured and sold are 20%, 30% and 50% respectively. The fixed operating costs plus interest costs to the firm is Rs148000. Calculate overall break-even quantity. Solve : WiCMi = W1CM1 + W2CM2 + W3CM3 = 0.2Rs50 + 0.3Rs40 + 0.5Rs30 = Rs37

Now overall break-even quantity, Q, will be

Q = Rs148000 / Rs37 = 40000 units The break-up of this quantity is as follows P = 40000 0.2 = 8000 units Q = 40000 0.3 = 12000 units R = 40000 0.5 = 20000 units Breakeven Quantity of Individual Products Many large firms are organised product-wise divisions. In this case, the break-even point for each product division has to be calculated seperately.

The following steps will be used i) determine the fixed costs of a product division as the sum of its seperable fixed costs and an allocated share of common or joint fixed costs. ii) calculate the break-even quantity of the product division as Fixed cost of the division Contribution margin For example : suppose a company is having three product divisions manufacturing products A, B and C. Other details are A(Rs) 40 20 110000 B(Rs) 30 16 60000 C(Rs) 20 12 40000

Unit selling price Unit variable cost Seperable fixed costs

The common fixed costs of the company are Rs200000. They are allocated to the three divisions in the ratio 5:3:2. Calculate the break even quantity for each product division. Solve :
The B-E quantity for each product division is calculated as follows-

A(Rs) seperable fixed cost 110000 allocated fixed cost 100000 total fixed costs 210000 contribution margin 20 B-E quantity 210000 20 = 10500

B(Rs) 60000 60000 120000 14 120000 14 = 8571

C(Rs) 40000 40000 80000 8 80000 8 = 10000

Limitations of C-V-P Analysis :

i) Complex cost structure :

many firms have such a complex cost structure that can not be classified into fixed or variable costs.
ii) Multiple products : in case of multi-product firms, it would be difficult to allocate the costs.

iii) Varying temporal incidences :

normally B-E analysis ignores time value of money. This is acceptable only if costs and revenue occurs more or less simultaneously. If they occur at different point of time, there are systematic differences in their temporal incidences.

iv) Non-linear relationship :

normally B-E analysis assumes linear relationship between unit variable cost (V) and the unit selling price (P) with output. Actually this is not the case. Inspite of its limitations, break-even analysis is a useful tool for profit planning in relatively simple situations.

Financial Leverage :
It refers to the extent to which the firm has fixed financing costs arising from the use of debt capital. A firm with high financial leverage will have relatively high fixed financing costs compared to a firm with low financial leverage.

Degree of Financial Leverage (DFL) :

It reflects the responsiveness of EPS to change in EBIT. It is defined as

EPS / EPS DFL EBIT / EBIT

It may be noted that, in operating leverage EBIT was dependent variable and was determined by sales level. But in FL, EBIT is an independent variable and it determines the level of EPS. Thus, EBIT is called as linking point in the leverage study. On substituting different values, final equation will be -

DFL

EBIT DP EBIT - I 1- T

Otherwise, financial leverage will be calculated as

FL = Operating Profit (Or EBIT) PBT (Or EBT) Favourable and unfavourable financial leverage : Financial leverage will be considered to be favourable so long the firm earns more on assets purchased on funds than the fixed costs of their use, otherwise it will be unfavourable. Trading on equity and financial leverage : FL is also sometimes termed as trading on equity. In general, the term trading on equity is used for financial leverage when financial leverage is favourable.

As we know, FL = EBIT / EBIT I the condition in which EBIT I = 0 i.e., the level of EBIT is just sufficient to cover the fixed financial charge only, this condition is known as financial break-even level. At this level, there is no earnings available to shareholders and there is no EPS. Applications of Financial Leverage :

It helps in
- understanding EPS change (due to change in EBIT) - measuring financial risk

Operating Leverage and Financial Leverage :

Both the OL and FL emerge for more or less the same reason.

The OL appears if the firm has fixed operating cost and FL appears when the firm has fixed financial charge.
The OL increases the variability of EBIT while FL increases the variability of EPS. The OL determines the level of fixed costs while FL determines the level of fixed financing costs i.e., extent of debt financing. Thus if OL and FL taken together intelligently, they will multiply and magnify the effect of change in sales level on the EPS.

Therefore, sometimes OL is also called as first order or first stage leverage and FL as second order or second stage leverage.

Total / Combined / Composite Leverage :

It expresses the relationship between sales (or contribution) and the taxable income. It helps in finding out the resulting percentage change in taxable income on account of percentage change in sales. This is calculated as TL = OL FL = Contribution EBIT EBIT PBT = Contribution PBT

Degree of Total Leverage (DTL) :

DTL is defined as

DTL = DOL DFL ; OR

EPS / EPS DTL ; OR Q / Q DTL Q(P - V) DP Q(P - V) - F - I 1- T

Application of Total Leverage :

DTL measures the percentage change in EPS which results from a change of 1 percent in Q. It helps in - understanding EPS change (due to change in sales revenue or contribution) - measuring total risk