Leverage Analysis In Financial Management

LEVERAGE ANALYSIS IN FINANCIAL MANAGEMENT AFTERSCHO☺OL

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LEVERAGE ANALYSIS IN FINANCIAL MANAGEMENT Dr. T.K. Jain.

AFTERSCHO☺OL Centre for social entrepreneurship Bikaner M: 9414430763 [email protected] www.afterschool.tk, www.afterschoool.tk let us change the world www.afterschoool.tk

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WHY STUDY LEVERAGE ? • It shows relation between various aspects – particularly risk and reward • Leverage is a relation of your efforts and rewards • Some factors like fixed cost resources etc have impact on increase or decrease in profit.

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WHAT IS LEVERAGE? • Lever is some tool to help you accelerate your speed – have you used it ???? • It increases your speed and also your risk. • We have two types of leverages in FINANCIAL MANAGEMENT : • A. operating leverage • B. financial leverage let us change the world

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WHAT IS FINANCIAL LEVERAGE? • Use of fixed charge securities like debentures in the overall capital structure is called financial leverage. • DFL = degree of financial leverage • It tells us about the level of financial risk that we are taking. If financial leverage increases, the risk of the firm increases.

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How is financial leverage measured? • % change in net income / % change in EBIT • EBIT = earnings before interest and taxes, it is also called net operating income • Net income = income after payment of all dues including interest. • Example : your EBIT is 1000, your interest is 500. your EBIT increases by 20%, interest remains same, so net income increases from 500 to 700. Thus DFL = 40/20 = 2 answer • (% change in net income is 40% due to increase in earning, but no change in interest). let us change the world

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What is operating leverage ? • It measures the impact of change in volume (sales) on EBIT. It measures the riskiness due to fixed cost resources in the organisation. • DOL = degree of financial leverage = % change in EBIT / % change in sales • It measures the impact of fixed cost on profitability let us change the world

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Example of operating leverage .. • Suppose your sales are 300 and your expenditures are 200. out of your total expenditure, 120 is fixed expenditure and and variable expenditureis 80. Suppose sales increase by 40%, the variable expenses will also increase by 40%. New sales = 420, new variable exp. = 112. New total exp. = 232. Profit changed from 100 to 188. • DOL = 88/40 = 2.2 ans. let us change the world

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What is DCL? • DCL = degree of combined leverage • DCL = DOL * DFL (PRODUCT OF DOL AND DFL)

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