its about the various kinds of leverages in financial management

1. Suresh T S
II PG M.Com
1
FINANCIAL MANAGEMENT
LEVERAGES

2. The dictionary meaning of the firm leverages refers to
"an increase means of accomplishing purpose".
In machines, leverages means the instrument that helps
us in lifting heavy objects, which may not be other wise
possible.
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LEVERAGE

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5. In financial Management the term ‘Leverage’ is used to
describe the firms ability to use fixed cost assets or funds to
magnify the return to its owners.
James Horne defines leverage as;
“The employment of an asset or source funds for which the
firm pays a fixed cost or a fixed return”
In business language, if a firm has fixed expenses in P/L
account or debt in capital structure, the firm is said to be
levered.
LEVERAGE IN THE AREA OF FINANCEFINANCE
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6. There are 3 types of leverages Viz;
1.Operating Leverage
2.Financial Leverage
3.Composite Leverage
The leverage associated with the employment of fixed cost asset is
referred to as operating leverage, While the leverage resulting from
the use of fixed cost/return source of fund is known as financial
leverage. Composite leverage focus on the entire income of the
concern.
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TYPES OF LEVERAGES

7. Operating leverage may be defined as the tendency of the
operating profit(EBIT) to vary disproportionately with sales.
Operating leverage is said to exist when a firm has to pay fixed
cost regardless the volume of output or sales.
Operating leverage in a firm is a function of 3 factors
1. The amount of Fixed cost
2. The Contribution margin (S-V)
3. The volume of sales
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OPERATING LEVERAGE

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OPERATING LEVERAGE CONTD…
Operating Leverage = Contribution
OP
Degree of OL = % Change in profits
%change in sales

9. Operating leverage increases with fixed cost. Operating profit
of a highly levered firm would increase at a faster rate for
any given increase in sales. However if sales fall, the firm
with a high operating leverage would suffer more loss than
the firm with no or low operating leverage. hence it is said
that operating leverage is a double edged sword.
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OPERATING LEVERAGE IS A ‘DOUBLE EDGED
SWORD’

10. Profit fluctuations occurring due to high fixed cost are
referred to as operating risk. Operating leverage is an
important determinant of operating risk.
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OPERATING RISK

11. Financial leverage may be defined as the tendency of the residual net
income (PBT) to vary disproportionately with operating profits
(EBIT).
It indicates the change that takes place in the taxable income as a
result of a change in the operating income.
It signifies the existence of fixed interest and or fixed dividend
bearing securities in the total capital structure of the company.
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FINANCIAL LEVERAGE

12. In other words the use of fixed interest or dividend bearing securities
such as debt and preference capital along with the owners equity in
the total capital structure of the company is defined as financial
leverage.
Favorable financial leverage
Unfavorable financial leverage
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FINANCIAL LEVERAGE CONTD…

13. The use of fixed charges sources of fund such as debt and
preference capital along with the owners equity in the
capital structure is called trading on equity or financial
leverage or gearing
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TRADING ON EQUITY / GEARING

14. Financial leverage = Operating Profit(EBIT)
Taxable Income (PBT)
Degree of FL = % change in taxable income
% change in operating profit
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FINANCIAL LEVERAGE CONTD…

15. Operating Leverage Financial Leverage
Operating leverage is concerned with
investment activities of the firm.
Financial leverage is concerned with
financing activities of the firm.
It is the firm’s ability to use fixed operating
costs to magnify the effects of changes in
sales on its earnings before interest and taxes.
It is the firm’s ability to use fixed financial
charges to magnify the effects of changes in
EBIT on tis earnings per share
It is determined by the cost structure of the
firm.
It is determined by the capital structure of the
firm.
The higher the proportion of fixed operating
costs to the total operating costs in the cost
structure of a firm, the higher is the degree of
operating leverage
The higher the proportion of fixe charges
bearing capital to total financial changes in
the capital structure of a firm, the higher is
the degrees of financial leverage.
Degree of operating leverage measure the
business risk associated with the firm
Degree of financial leverage measure the
degree of financial risk, associated with the
firm.
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DIFFERENCE BETWEEN FINANCIAL LEVERAGE
AND OPERATING LEVERAGE

16. Combined leverage is the leverage obtained by combining operating
leverage and financial leverage. Composite leverage discloses the
effect of change in sales on taxable profit ie; EPS
Composite leverage expresses the relationship between revenue on
account of sales (ie; contribution) and taxable income. It helps in
finding out the percentage change in taxable income on account of
percentage change in sales.
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COMBINED LEVERAGE/ COMPOSITE LEVERAGE

17. Combined leverage = OL * FL
Contribution
PBT
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COMBINED LEVERAGE CONTD…

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