Operating And Financial Leverage 6p581m

MEANING OF OPERATING AND FINANCIAL LEVERAGE Operating leverage occurs any time a firm has fixed cost that must be met regardless of volume. operating leverage is the technique of magnifying the EBIT by using fixed costs that must be met regardless of volume in the capital structure. An entrepreneur generally employ assets with a fixed cost in the hope that volume will produce revenues more than sufficient to cover all fixed and variable costs. For example in an airline industry, a large portion of total cost are fixed. B1eyond the break-even point each additional enger represents essentially straight profit to the airline. So is the case of a bus or railway and so on. With fixed costs, the percentage change in profit accompanying a change in volume is greater than the percentage change in volume. This occurace is known as operating leverage. Operating leverage can be explained better by means of break-even or costvolume-profit analysis. Financial Leverage may be defined as the use of fixed financial charges in the firm’s capital structure to magnify the Earning Per Share. Financial leverage occurs when funds with charges, such as debt and preference share are used with the owner’s equity in the capital structure. The financial leverage is employed by a company with an intention to earn more on fixed charges funds than their costs. It amy be compared to a fulcrum used in physics in the sense that the surplus over interest cost will be used as a lever or fulcrum to increase the return on the owner’s equity which is projected by an increase in the EPS. For example, if a company borrows tk. 100 at 10 per cent interest. This is also termed as ‘trading on the equity’ in the sense that here the owner’s equity is used as a basis to raise debt.

Distinction between Operating Leverage and Financial Leverage Points of Differences Operating Leverage 1. Definition Operating Leverage may be defined as the use of fixed cost in the firm’s cost structure to magnify the Earning Before Interest and Taxes

Financial Leverage Financial Leverage may be defined as the use of fixed financial charges in the firm’s capital structure to magnify the Earning Per Share.

2.Relationship

Operating leverage lies in the cost Financial leverage lies in structure of the firm financial structure of the firm

the

3. Sources

The source of operating leverage is The source of financial leverage is fixed cost of the firm like fixed financial charge of the firm depreciation. like interest

4. Projection

Effects of Operating leverage is Effects of Financial projected on EBIT isprojected on EPS

5. Calculation

Operating leverage is calculated as: Percentage change in EBIT Percentage change in sales

6. Avoidability

Operating leverage can not be Financial leverage can be avoided avoided as fixed cost is a must. by not incorporating any debt.

7. Existence

Whenever the percentage change in EBIT resulting from a geven percentage change in sales is greater than the % change in sales, Operating leverage exists.

8. Creation of risk

Operating leverage creates business Financial leverage creates financial risk. risk.

9. Favourable

If sale exceeds BEP or, Sales price If cost of borrowed is less than the rises or, variable cost decreases cost of equity

leverage

Financial leverage is calculated as: Percentage change in EPS Percentage change in EBIT

Whenever the percentage change in EPS resulting from a geven percentage change in EBIT is greater than the % change in EBITs, Financial leverage exists.

10.Justification of use

Use of OL is justified if there is a Use of Financial leverage is possibility to increase sales. justified if there is a possibility to increase EPS Aalysis of OL gives management a Aalysis of FL helps evaluate good deal of information about the various financing plan of the operating risk of the company company.

11. Benefit

PROBLEM ON LEVERAGE Balance Sheet of Harding Co as on 31st December 2005 Particulars Current Assets Net Fixed Assets Total Assets

Amount 3,00,000 5,00,000 8,00,000

Particulars Debt Capital (10%) Common Stock Total Capital

Amount 2,00,000 6,00,000 8,00,000

Other information Particulars Sales of Tooth Brush 20000 units@ tk. 20 each) Less: Variable cost @ tk. 10 p.u. Fixed cost (operating) taxes (40%)

Taka 4,00,000 2,00,000 80,000

Number of shares outstanding is 6000 company compute the following: i. ii.

Degree of operating leverage, Degree of financial leverage and Degree of total leverage You are also required to show the effect of operating leverage on EBIT and the effect of financial leverage on EPS if the company increases its sale by 50 percent.

SOLUTION: Sales in Units Sales of Tooth Brush 20000 units@ tk. 20 each) Less: Variable cost @ tk. 10 p.u.

20,000 Units tk. 4,00,000 tk. 2,00,000

30,000 Units (50% increase) tk. 6,00,000 tk. 3,00,000

Contribution Less fixed cost (operating)

tk. 2,00,000 tk 80,000

tk. 3,00,000 tk. 80,000

Earning Before Interest and Taxes (EBIT) Less Interest expenses on debt

tk. 1,20,000 tk. 20,000

tk. 2,20,000 tk. 20,000

Earning before taxes (EBT) Less: taxes (40%) Earning after tax (EAT)

tk. 1,00,000 tk. 40,000 tk. 60,000 tk. 10

tk. 2,00,000 tk. 80,000 tk, 1,20,000 tk. 20

Earning Per Share Percentage Change in EBIT

2,20,000  1,20,000 X 100 1,20,000

= 83.33%

20  10 X 100 10

Percentage Change in EPS Percentage Change in Sales Degree of Operating Leverage

Degree of Financial Leverage

Degree of Total Leverage

= 100% 50% CM EBIT

PercentageChangeinEBIT Percentagechangeinslaes

2,00,000 =1.67 times 1,20,000

83.33 = 1.67 times 50%

EBIT EBT

PercentageChangeinEPS PercentagechangeinEBIT

1,20,000 =1.2 times 1,00,000

100 = 1.2 times 83.33

DOL X DFL 1.67 X 1.2 = 2 times

PercentageChangeinEPS PercentagechangeinSales

100 = 2 times 50