Leverage Assignment Help
Leverage is defined as the risk-taking capacity of the organization that how much risk the company can bear in a given period of time, the risk here means the paying back the interest amount on the financial loans and paying the operating or fixed expenses of a company.
According to J. C. Van Home “Leverage is the employment of an asset or funds for which the firm pays a fixed cost of fixed return.”
Types of Leverages: -
- Operating Leverage
- Financial Leverage
- Combined Leverage
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Operating Leverage
Operating leverage is the cost of fixed asset procured by a company and the operating fixed costs of a company that incurred in the day to day activities such as repairs and maintenance, depreciation, insurance of assets, property taxes etc.
The formula for calculating the operating leverage or the operating leverage ratio is:-
The degree of operating leverage= percentage change in EBIT/ percentage change in Sales
Percentage change in EBIT= Increase in EBIT/EBIT
Percentage change in Sales = Increase in Sales/ Sales
The degree of operating leverage can also be computed as
DOL = Contribution / EBIT
Higher is the degree of operating leverage, the better it is.
If the value of the degree of operating leverage is 1 it means there is no operating leverage or operating risk in the company.
For Example 1:-
Calculate degree of operating leverage from the following :-
Sales - $100,000
Variable cost - $ 30,000
Fixed cost - $ 10,000
Solution –
Sales = $100000
Variable cost = $30000
Contribution = Sales – Variable cost
Contribution = $70000
EBIT (Earning before interest and tax) = Contribution – Fixed cost
EBIT = $70000- $10000
EBIT = $60000
Degree of operating leverage = Contribution / EBIT
DOL = $ 70000/ $ 60000
DOL = 1.167
Example 2:-
Calculate the degree of operating leverage from the following:-
Sales in 2018 were $150000 and Sales in 2019 is $250000, EBIT in 2018 was $10000 and EBIT in 2019 is $15000. Compute DOL.
Solution -
Degree of Operating Leverage = % change in EBIT/ % change in Sales
% change in EBIT= increase in EBIT/ EBIT
% change in EBIT = $5000/$10000
% change in EBIT = 50%
% change in Sales = Increase in Sales / Sales
% change in Sales = $100000/$150000
% change in Sales = 66.67%
DOL = % change in EBIT / % change in Sales
DOL = 50%/66.67%
DOL = 0.75
Financial Leverage
Financial leverage is the cost of interest incurred on financial capital raised from the market by the company.
The formula for calculating the financial leverage or the financial leverage ratio is:-
The degree of financial leverage= percentage change in EPS/ percentage change in EBIT
Percentage change in EPS= Increase in EPS/EPS
Percentage change in EBIT= Increase in EBIT/EBIT
Degree of financial leverage can also be computed as
DFL = EBIT / EBIT – Interest – preference dividend (if any)
DFL = EBIT/ EBT
Lower the financial leverage ratio the better it is.
This shows the company is having a lower amount of debt.
Example 3 :-
Calculate degree of financial leverage from the following :-
Sales - $100,000
Variable cost - $ 30,000
Fixed cost - $ 10,000
Interest on 10% Debenture of $ 100,000
Solution –
Sales = $100000
Variable cost = $30000
EBIT (Earnings before interest and tax) = Sales – Variable cost – fixed cost
EBIT (Earnings before interest and tax) = $100000- $30000 - $ 10000
EBIT = $60,000
EBT (Earnings before tax) = EBIT – interest on debenture
EBT = $60,000- $10,000
EBT = $50,000
DFL= EBIT/EBT
DFL= $60,000/$50,000
DFL = 1.2
Example 4:-
Calculate the degree of financial leverage from the following:-
EPS in 2018 was $15 and the EPS in 2019 is $25, EBIT in 2018 was $10000 and EBIT in 2019 is $15000. Compute DFL.
Solution –
Degree of Financial Leverage = % change in EPS/ % change in EBIT
% change in EBIT= increase in EBIT/ EBIT
% change in EBIT = $5000/$10000
% change in EBIT = 50%
% change in EPS = Increase in EPS / EPS
% change in EPS = $10/$15
% change in EPS = 66.67%
DFL = % change in EPS / % change in EBIT
DFL = 66.67% / 50%
DFL = 1.33
EXAMPLE 5:-
Calculate the Degree of financial leverage ratio from the following data of ABC company (UK) :-
Sale = $200,000
Variable cost = $ 100,000
Fixed cost = $ 20,000
10% debentures of $ 100,000 and 10% preference shares of $ 200,000 are borrowed from the market.
Solution –
EBIT (Earnings before interest and tax) = Sales – Variable cost – Fixed cost
EBIT= $200,000 - $ 100,000 - $ 20,000
EBIT = $ 80,000
EBT (Earnings before tax) = EBIT – Interest on debenture – preference dividend
EBT = $80,000 - $10,000 - $ 20,000
EBT = $ 50,000
DFL = EBIT/EBT
DFL = $80,000/ $50,000
DFL = 1.6
Combined Leverage
The degree of combined leverage is the combined effect of the operating leverage ratio and financial leverage ratio. It shows the effect of a change in sales on the change of earning EPS share.
The formula for calculating the combined leverage or the combined leverage ratio is:-
The degree of combined leverage= percentage change in EPS/ percentage change in Sales
Percentage change in EPS= Increase in EPS/EPS
Percentage change in Sales = Increase in Sales/ Sales
Degree of combined leverage can also be computed as
DCL = Sales – Variable cost / EBIT – Interest – preference dividend (if any)
DCL = Contribution / EBT
DCL = DOL* DFL
Lower the combined leverage ratio the better it is.
This shows the amount of fixed cost and amount of financial debt that the company is having in the given period of time.
Example 6 :-
Calculate the Degree of combined leverage ratio from the following data of XYZ company (UK) :-
Sale = $200,000
Variable cost = $ 100,000
Fixed cost = $ 20,000
10% debentures of $ 100,000 and 10% preference shares of $ 200,000 are borrowed from the market.
Solution –
Contribution = Sales – Variable cost
Contribution = $ 200,000 - $ 100,000
Contribution = $ 100,000
EBT (Earnings before tax) = Contribution – Fixed cost – Interest on debenture – Preference dividend
EBT= $ 100,000 - $20,000 - $10,000 -$ 20,000
EBT = $ 50,000
DCL = Contribution / EBT
DCL = $100,000/ $50,000
DCL = 0.5
Example 7:-
Calculate the Degree of operating leverage, Degree of Financial Leverage and Degree of combined leverage from the following given data:-
Sales = $500,000
Variable cost = $ 200,000
Fixed cost = $ 100,000
The company is having 10% debentures of $ 200,000 and 10% preference shares of $ 300,000.
Solution: -
Calculation of Degree of Operating Leverage -
DOL= Contribution / EBIT
Contribution = Sales – Variable cost
Contribution = $500,000 - $ 200,000
Contribution = $ 300,000
EBIT (Earnings before Interest and Tax) = Contribution – Fixed cost
EBIT = $ 300,000 - $ 100,000
EBIT = $ 200,000
DOL = Contribution / EBIT
DOL = $ 300,000/ $200,000
DOL = 1.5
Calculation of Degree of Financial Leverage –
DFL = EBIT / EBT
EBIT = $ 200,000
EBT (Earnings before tax) = EBIT – Interest on debenture – Preference dividend
EBT = $200,000 - $ 20,000 - $ 30,000
EBT = $ 150,000
DFL = EBIT / EBT
DFL = $200,000/ $ 150,000
DFL = 1.33
Calculation of Degree of Combined Leverage -
DCL = DOL * DFL
DCL = 1.5 * 1.33
DCL = 1.99
