Tuesday, May 8, 2018

Financial leverage and Operating leverage

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The term leverage generally, refers to a relationship between 2 interrelated variables.

In financial analysis, it represents the influence of one financial variable over some other related financial variable. These financial variables may be costs, output, sales revenue, EBIT (Earnings Before Interest and Tax), EPS (Earnings Per Share), etc.

Type of leverage : 

Commonly used leverages are of the following type:

1) Operating Leverage :
It is defined as the "firm's ability to use fixed operating costs to magnify effects of changes in sales on its EBIT ". When there is an increase or decrease in sales level the EBIT also changes. The effect of changes in sales on the level EBIT is measured by operating leverage.

Operating leverage =

% Change in EBIT / % Change in sales

=[Increase in EBIT/EBIT] / [Increase in sales/sales]

Significance of operating leverage :
Analysis of operating leverage of a firm is useful to the financial manager. It tells the impact of changes in sales on operating income. A firm having higher D.O.L. (Degree of Operating Leverage) can experience a magnified effect on EBIT for even a small change in sales level.

Higher D.O.L. can dramatically increase operating profits. But, in case of decline in sales level, EBIT may be wiped out and a loss may be operated. As operating leverage, depends on fixed costs, if they are high, the firm's operating risk and leverage would be high.

If operating leverage is high, it automatically means that the break-even point would also be reached at a high level of sales. Also, in case of high operating leverage, the margin of safety would be low. Thus, it is preferred to operate sufficiently above the break-even point to avoid the danger of fluctuations in sales and profits.

2) Financial Leverage :
It is defined as the ability of a firm to use fixed financial charges to magnify the effects of changes in EBIT/Operating profits, on the firm's earnings per share. The financial leverage occurs when a firm's capital structure contains obligation of fixed charges e.g. interest on debentures, dividend on preference shares, etc. along with owner's equity to enhance earnings of equity shareholders.

The fixed financial charges do not vary with the operating profits or EBIT. They are fixed and are to be repaid irrespective of level of operating profits or EBIT. The ordinary shareholders of a firm are entitled to residual income i.e. earnings after fixed financial charges. Thus, the effect of changes in operating profit or EBIT on the level of EPS is measured by financial leverage.

Financial leverage =

% change in EPS/% change in EBIT
= (Increase in EPS/EPS)/{Increase in EBIT/EBIT}

The financial leverage is favourable when the firm earns more on the investment/assets financed by sources having fixed charges.

It is obvious that shareholders gain a situation where the company earns a high rate of return and pays a lower rate of return to the supplier of long term funds, in such cases it is called 'trading on equity'.

The financial leverage at the levels of EBIT is called degree of financial leverage and is calculated as ratio of EBIT to profit before tax.

Degree of financial leverage = EBIT/Profit before tax

Shareholders gain in a situation where a company has a high rate of return and pays a lower rate of interest to the suppliers of long term funds. The difference accrues to the shareholders.

However, where rate of return on investment falls below the rate of interest, the shareholders suffer, as their earnings fall more sharply than the fall in the return on investment.

Financial leverage helps the finance manager in designing the appropriate capital structure. One of the objective of planning an appropriate capital structure is to maximise return on equity shareholders' funds or maximise EPS.

Financial leverage is double edged sword i.e. it increases EPS on one hand, and financial risk on the other. A high financial leverage means high fixed costs and high financial risk i.e. as the debt component in capital structure increases, the financial risk also increases i.e. risk of insolvency increases. The finance manager thus, is required to trade off i.e. to bring a balance between risk and return for determining the appropriate amount of debt in the capital structure of a firm.
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Thus, analysis of financial leverage is an important tool in the hands of the finance manager who are engaged in financing the capital structure of business firms, keeping in view the objectives of their firm.

3) Combined leverage :
Operating leverage explains operating risk and financial leverage explains the financial risk of a firm. However, a firm has to look into overall risk or total risk of the firm i.e. operating risk as also financial risk.

Hence, the combined leverage is the result of a combination of operating and financial leverage. The combined leverage measures the effect of a % change in sales on % change in EPS.

Combined Leverage =

Operating leverage * Financial leverage

= (% change in EBIT/% change in sales) * (% change in EPS/% change in EBIT)

= % change in EPS/% change in sales

The ratio of contribution to earnings before tax, is given by a combined effect of financial and operating leverage. A high operating and high financial leverage is very risky, even a small fall in sales would affect tremendous fall in EPS.

A company must thus, maintain a proper balance between these 2 leverage. A high operating and low financial leverage indicates that the management is careful as higher amount of risk involved in high operating leverage is balanced by low financial leverage.

But, a more preferable situation is to have a low operating and a high financial leverage. A low operating leverage automatically implies that the company reaches its break-even point at a low level of sales, thus, risk is diminished. A highly cautious and conservative manager would keep both its operating and financial leverage at very low levels. The approach may, mean that the company is losing profitable opportunities.

The study of leverages is essential to define the risk undertaken by the shareholders. Earnings available to shareholders fluctuate on account of 2 risks, viz. operating risk i.e. variability of EBIT may arise due to variability of sales or/and expenses.

In a given environment, operating risk cannot be avoided. The variability of EPS or return on equity depends on the use of financial leverage and is termed as financial risk. A firm financed totally by equity finance has no financial risk, hence it cannot be avoided by eliminating use of borrowed funds.

Thus, a company has to consider its likely profitability position set before deciding upon the capital mix of the company, as it has far reaching implications on the financial position of the company.

Effect of leverage on capital turnover and working capital ratio

An increase in sales improves the net profit ratio, raising the Return on Investment (R.O.I) to a higher level. This however, is not possible in all situations, a rise in capital turnover is to be supported by adequate capital base.

Thus, as capital turnover ratio increases, working capital ratio deteriorates, thus, management cannot increase its capital turnover ratio beyond a certain limit. The main reasons for a fall in ratios showing the working capital position due to increase in turnover ratios is that as the activity increases without a corresponding rise in working capital, the working capital position becomes tight.

As the sales increases, both current assets and current liabilities also increases but not in proportion to current ratio. If current ratio and acid test ratio are high, it is apparent that the capital turnover ratio can be increased without any problem.

However, it may be very risky to increase capital turnover ratio when, the working capital position is not satisfactory.
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