Q.1. What is meant by Leverage? What are the commonly used leverages in financial analysis?
(a) The leverage in general, refers to advantage gained for any purpose.
(b) In financial analysis, Leverage is used by business firms to quantify the risk return relationship of different alternative capital structures.
(c) Study of leverage is essential to define the risk undertaken by the shareholders.
Earnings available to shareholders fluctuate on account of two risks.
• VARIABILITY OF EBIT
Operating Risk: arises due to variability of sales and variability of expenses.
• VARIABILITY OF EPS OR ROE
Financial Risk: arises due to the impact of interest charges.
(d) There are three commonly used measures of leverage in financial analysis. These are:
• Operating Leverage
• Financial Leverage
• Combined Leverage
Q.3. Bring out the meaning and significance of Financial Leverage.
Financial Leverage is defined as the ability of a firm to use fixed financial charges (interest) to magnify the effects of changes in E.B.I.T./ Operating profits, on the firm's Earning Per Share (EPS).
Financial Leverage occurs when a Company has debt content in its capital structure and fixed financial charges e.g. interest on debentures. These fixed financial charges do not vary with the EBIT. They are fixed and are to be paid irrespective of level of EBIT.
Hence an increase in EBIT will lead tn a higher percentage increase in Earnings per Share (EPS). This is measured by the Financial Leverage.
The degree of Financial Leverage (DFL) is measured as under: (expressed in times)
• Effect on EPS : DFL measures the impact of change in EBIT (Operating Income) on EPS (earnings peir share). Suppose DFL of a firm is 4 times, it implies that 1% change in EBIT will lead to 4% change in EPS. Hence, if EBIT increases by 10%, EPS incieases by 10% X 4 = 40%. Also, if EBIT decreases by say 5%, EPS falls by
• Impact of Fixed Financial Charges: DFL depends on the magnitudes of interest and fixed financial charges. If these costs are higher, DFL is higher and vice-versa.
• Effect of High DFL: If DFL is high, it implies that fixed interest charges are high. This means that the financial risks are higher. The DFL is considered to be favourable or advantageous to the firm, when it earns more on its total investment than what it pays towards debt capital. In other words, DFL is advantageous only if Return on Capital Employed (ROCE) is greater than Rate of Interest on Debt.
Q.5. Outline the significance of combined leverage.
Combined Leverage is used to measure the total risk or a firm = Operating Risk + Financial Risk
Effect of Fixed Operating Costs (i.e Operating Risks) is measured by Operating Leverage (DOL). Effect of Fixed interest Charges (i.e. Financial Risks) is measured by Financial Leverage (DFL). The combined effect of these is measured by Combined Leverage (DCL).
The degree of Combined Leverage (DCL) is measured as DOL x DFL. Therefore, DCL = Contribution / EBT
DOL measures impact of change in Sales on EBIT. DFL measures the impact of change in EDIT on EPS. DCL measures the combined impact, i.e. effect of change in Sales on EPS. If DCL is 2 times, it implies that a 10% increase in Sales will lead to 20% increase in EPS.
Q.6. Should increase in activity levels (Sales) be supported by increase in capital Employed?
(1) Increase in Sales leads to increase in EBIT, EBT and ROI. Hence, a fiml may be tempted to try to raise its Capital Turnover Ratio (Sales divided by Capital Employed) without restraint.
(2) However, as Capital Turnover Ratio increases, Working Capital Ratio deteriorates.
(3) As sales increases, both Current Assets and Current Liabilities also increse but not in proporation to the current ratio, with the same amount of funds employed. Hence Current Ratio registers a fall and affetcts the liquidity position of the firm adversely.
(4) Hence, arise in capital turnover must be supported by an adequate capitla base and increase in the amount of funds employed, more particulary in Working Capital.
DISADVANTAGES OF OPERATION LEVERAGE
# The reliablity of operating ratio rests to a large extent on the correctness of the fixed costs identified with a product. Faulty apportionment would distort the usefulness of the ratio.
# The published accounts does not give details of the fixed cost incurred and the contribution from each product and for an outsider it is difficult to calcualte the firm’s operating leverage.
Firm’s cost structure and nature of the firm’s business affect operating leverage. It is intereseting to note that a degree of change in sales volume results in a more than proportionate changes, in operating profit (or loss) can be observed can be obseved by the use of operating leverage.