Leverage

Leverage in the general sense means influence of power i.e. utilising the existing resources to attain something else. Leverage in terms of financial analysis is the influence which an independent financial variable has over a dependent or related variable. When leverage is measured between two financial variables it explains how the dependent variable responds to a particular change in the independent variable. Algebraically, the leverage may be defined as:

Measures of Leverage: To better understand the importance of leverage in financial analysis, it is imperative to understand the three measures of leverage.
1. Operating Leverage
2. Financial Leverage
3. Combined or Total Leverage
1. Operating Leverage: Operating leverage examines the effect of change in the quantity produced on the EBIT (Earnings before Interest and Taxes) of a firm. It refers to the use of fixed costs in the operation of the firm. If the firm has fixed costs, it would have operating leverage and the percentage change in the operating profit would be more for a given change in the costs. Operating profit of a highly leveraged firm would increase at a faster rate for any given increase in sales and it would suffer more loss than an unleveraged firm if the sales fall.
Operating leverage is measured in terms of Degree of Operating Leverage, (DOL) which is defined as the ratio of percentage change in EBIT to percentage change in output.

Where EBIT = Q(S-V)-F; S is selling price per unit; V is variable cost per unit; F is fixed cost per unit and Q is the quantity produced.
The DOL can also be computed as:

Applications of Operating Leverage:
1. DOL helps in determining the behaviour of EBIT when the level of output is changed. A higher DOL indicates that even small fluctuations in the output will significantly affect the level of operating income.
2. DOL measures the business risk associated with a firm. A higher DOL implies greater uncertainty or variability in the firm’s EBIT and hence greater business risks.
3. A firm can plan its production based upon the effect of producing a particular level of output on the DOL.

Determining Behaviour of EBIT: DOL helps in ascertaining change in operating income for a given change in output (quantity produced and sold). A large DOL indicates that small fluctuations in the level of output will produce large fluctuations in the level of operating income.
a) Measurement of Business Risk: Business risk refers to the uncertainty or variability of the firm’s EBIT. So, everything else being equal, a higher DOL means higher business risk and vice versa.
b) Production Planning: DOL is also important in production planning. For e.g., the firm may have the opportunity to change its cost structure by introducing labour – saving machinery, thereby reducing variable labour overhead while increasing the fixed cost. Such a situation will increase DOL.
2. Financial Leverage: Financial Leverage measures the effect of the change in EBIT of the company on its EPS.
Financial leverage is measured in terms of Degree of Financial Leverage, which is computed as:

Q is the quantity produced; S is the selling price per unit,
V is the variable cost per unit,
F is the fixed cost,
I represent the interest payments,
Dp is the preference dividend paid and T is the corporate tax rate.
DFL can also be computed as: