lecture 11 leverage

Amity Business School

1

Amity Business School Semester II

FINANCIAL MANAGEMENT

Module (Leverage Analysis)


Financial Leverage

•The Financial Leverage measures the relationship between the EBIT and the EPS.

•It reflects the effect of a change in EBIT on the level of EPS.

• It results from the presence of fixed financial charges (such as interest on debt and dividend on preference shares).


Sales Revenues (S) EBIT

- Variable Cost (V) - Interest

Contribution (PBT) Profit Before Tax

- Fixed Cost (F) - Tax

EBIT (PAT) Profit After Tax

- Preference Dividend

Earnings available for equity shareholders

EPS = Earnings available for equity shareholders No. of Shares


EBIT%Δ

PSE%ΔDFL =

Degree of Financial Leverage (DFL)

EPS

•The degree of financial leverage (DFL) can be calculated as:

eentVariablinIndepend

tVariableinDependen

∆∆

%

%=


•Financial leverage is related to the financing activities of a firm.

•Since such financial expenses do not vary with the operating profits, financial leverage is concerned with the effect of changes in EBIT on the earnings available to equity-holders.

•It is defined as the ability of a firm to use fixed financial charges to magnify the effect of changes in EBIT on the earnings per share (EPS).


Therefore Financial leverage can be written as-

EBIT

Financial Leverage =

EBT

EBT = EBIT- Interest

EBT is also called PBT

Amity Business SchoolTipWhenever, there is a change in the “level of activity” and Financial Leverage is to be found out, then use the formula-

But, whenever Financial Leverage is to be found out for “status-quo” or for the “current level of activity” then use the formula

EBIT%Δ

PSE%ΔDFL = EPS

EBIT

Financial Leverage =

EBT – (Preference Dividend)

(1-tax rate)


Calculate Financial Leverage from the following data-

Year 1 Base Year Year 3

EBIT Rs 30,000 Rs 50,000 Rs 70,000

Number of shares 10,000 10,000 10,000

Tax Rate 35%


Year 1 Base Year 3

– 40% +40%

EBIT Rs 30,000 Rs 50,000 Rs 70,000

Less: Taxes (0.35) 10,500 17,500 24,500

Earnings available for equity-holders

19,500 32,500 45,500

Number of shares 10,000 10,000 10,000

EPS 1.95 3.25 4.55

– 40% +40%


Degree of financial leverage (DFL): Applying-

(i) From Base year to year 3 = (+40% / + 40%) = 1(ii) From Base year to year 1 = (-40% / -40%) = 1

Thus, the quotient is 1. Its implication is that 1 per cent change in EBIT will result in 1 per cent change in EPS, that is, proportionate. There is, therefore, no magnification in the EPS. There is no Financial Leverage

EBIT%Δ

PSE%ΔDFL = EPS


•Financial leverage exists only when there are fixed Financial costs (e.g. Interest on Debentures, Preference Dividend) .

•If there are no fixed Financial costs, there will be no Financial leverage.


e.g.…The financial manager of the Hindustan Chemicals Ltd expects that its earnings before interest and taxes (EBIT) in the current year would amount to Rs 10,000.

The firm has 5 per cent Bonds aggregating Rs 40,000, while the 10 per cent Preference Shares amount to Rs 20,000. What would be the earnings per share (EPS)?

The EBIT are as follows-Year 1 Rs 10,000, Year 2 Rs. 14,000 ;

How would the EPS be affected? Calculate Financial Leverage.

The firm can be assumed to be in the 35 per cent tax bracket. The number of outstanding ordinary shares is 1,000.


Year 1 Year 2

(% Change in EBIT) (Base Year) +40%

EBIT

Less: Interest on bonds

Earnings before taxes (EBT)

Less: Taxes (35%)

Earning after taxes (EAT)

Less: Preference dividend

Earnings available for ordinary shareholders

Earnings per share (EPS)

(% Change in EPS)

Rs 10,000

(2,000)

8,000

(2,800)

5,200

(2,000)

3,200

3.2

Rs 14,000

(2,000)

12,000

(4,200)

7,800

(2,000)

5,800

5.8

(Base Year) +81.25%


2.03, 40%

81.25% DFL =

++=


•A 40% increase in EBIT (from Rs 10,000 to Rs 14,000) results in 81.25 % increase in EPS (from Rs 3.2 to Rs 5.8).

•Thus, a 40% increase in the firm’s EBIT results in a more than proportional increase in the firm’s EPS.

Interpretation


Financial Leverage is a measure of the amount of debt used by a firm

Degree of Financial Leverage (DFL) = %age in EPS / %age in EBIT


Leverage Means Risk

• Leverage is a double-edged sword• It magnifies profits as well as losses• An aggressive or highly leveraged firm has a

relatively high break-even point (and high fixed costs)

• A conservative or non-leveraged firm has a relatively low break-even point (and low fixed costs)


• Sales (total revenue) (80,000 units @ $2) $160,000— Fixed costs 60,000— Variable costs ($0.80 per unit) 64,000

Operating income $ 36,000Earnings before interest and taxes $ 36,000— Interest 12,000

Earnings before taxes 24,000— Taxes 12,000

Earnings after taxes $ 12,000Shares 8,000Earnings per share $1.50

Operatingleverage

Financialleverage


Significance

• The term leverage refers to a relationship between two interrelated variables.

• In financial analysis, the leverage reflects the responsiveness or influence of one financial variable over some other financial variable.

• It quantifies the relative changes in profit due to change in the sales. It depicts the change in fixed costs incurred to sell the goods.


• It helps the management in controlling operating costs or varying the profit with an element of risk.

• It also helps in forecasting. • It helps in understanding the relationship between any

two variables. • However, the two variables for which the relationship

is to be established should be interrelated, otherwise, the leverage study may not have any useful purpose to serve.


Master Table to Calculate the LeverageSales

Less: Variable Cost

Contribution

Less: Fixed Cost

Operating Profit or EBIT

Less: Interest

Earning before Tax (EBT)

Less: Tax

Earning after Tax

Less: Preference Dividend

Earning Available to Equity Shareholder


Difference between Operating & Financial Leverage

Operating Leverage Financial Leverage

Operating Leverage is related to the investment activities (capital expenditure decision)

Financial leverage is more concerned with financial matters. (Capital structure or Debt & equity mix)

The Fluctuation in the EBIT can be predicted with the help of operating leverage.

The change of EPS due to Debt equity mix is predicted by financial leverage.

Financial Manager Uses the operating leverage to identify the items of assets side of Balance Sheet.

The use of financial leverage is to make decision in the liability side of the Balance sheet.

Operating leverage is used to predict Business risk.

Financial leverage is used to analyses the financial risk.

lecture 11 leverage

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