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LEVERAGES

LEVERAGES. LEVERAGES. It is the firm’s ability to use fixed cost assets or Sources of funds to magnify the returns to its owners “The employment of an asset or sources of funds for which the firm has to pay a fixed cost or fixed return” James Home. TYPES OF LEVERAGES.

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LEVERAGES

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  1. LEVERAGES

  2. LEVERAGES • It is the firm’s ability to use fixed cost assets or • Sources of funds to magnify the returns to its owners • “The employment of an asset or sources of funds for which the firm has to pay a fixed cost or fixed return” • James Home

  3. TYPES OF LEVERAGES • 1.OPERATING LEVERAGE • 2. FINANCIAL LEVERAGE

  4. 1.Operating Leverage: • Firm’s ability to use operating costs • Purpose – magnify the effect of changes in sales on its earning before interest and taxes

  5. Operating cost are three types: • Fixed cost • Variable cost • Semi-variable cost • High degree of operating leverage indicates high degree of risk • Operating risk(business risk)-firm is not being able to cover its fixed operating costs

  6. Degree of operating leverage –”Change in the percentage of operating income(EBIT), for change in percentage of sales revenue” • Degree of Operating Leverage =% change in EBIT/% change in sales

  7. OR • Contribution/Operating Profit(EBIT) • Application: • It is helpful to know how operating profit (EBIT) would change with a given change in units produced • It will be helpful in measuring business risk

  8. Financial Leverage • Long- terms funds for long-term activities like expansion , diversification , modernization • Long term source- equity and debt • The use of fixed charges , sources of funds such as debt and preference share capital along with the equity share capital in capital structure is described as financial leverage

  9. Financial leverage = • EBIT or operating profit/EBT or taxable income • Degree of financial leverage(DFL)= • % Change in EPS/% Change in EBIT • Application: How EPS would change with a change in operating profit(EBIT) • It will helpful for measuring the financial leverage

  10. Combined Leverage: • The degree of combined leverage may be defined as the percentage change in EPS due to the percentage change in sales • = % change in EPS /% change in sales or • Contribution/EBT

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