Leverage

LEVERAGE An increased means for accomplishing some purpose

 Leverage helps us in lifting heavy objects,

which may not be otherwise possible

 The term leverage is used to describe the

firm’s,ability to use fixed cost assets or funds to magnify the returns to its owners.

Types of leverage  Operating leverage  Financial leverage  Combined leverage

 Operating leverage: it relates to the sales

and profit variations.  Operating leverage is the firm’s ability to use the fixed operating costs to magnify the effects of changes in sales on its earning before interest and tax.

 Degree of Operating leverage=contribution

/EBIT

 Financial leverage: it indicates the effects

on earnings due to rise of fixed cost funds.  Financial leverage is the ability of the firm to use fixed financial charges to magnify the effect of change in earnings per share.  Degree of financial leverage=EBIT/EBT

 Combined leverage:  It is combination of both leverage.  Degree of combined

leverage=contribution\EBT

 Importance of leverage:  It helps in examining a relative change in the

profits due to changes in sales.  It helps in bifurcating the fixed costs into fixed operating costs and fixed financial costs and thus examine its impact on the profits of the firm at differently.  Leverage helps in determining the EPS of the company.

 Margin of safety :it is the excess sales over

the Break-Even Sales. It is the difference between actual sales and Break-even sales.

 Break Even analysis: it indicates at what

level costs and revenue are in equilibrium