OPERATING AND FINANCIAL LEVERAGE

ACC 609 (DR ABGOR):

GROUP 15
INTRODUCTION
In the pure Sciences precisely in Mechanics the concept of leverage refers to a technique
whereby more weight is raised with little or less power. In the Social Sciences precisely the field
of financial management, leverage exist when fixed cost is incurred. When a firm makes use of
any part of fixed cost capital then, the firm is said to have leverage and it can be used to increase
profitability and increase the firm’s financial strength.
DEFINITION
Leverage can be defined as a fixed cost or the payment of a fixed return for funds employed. It
can also be further defined as the use of the loan or debt capital of a business to undertake or
carryout investments or projects. It is a common tool used to boost an organization’s equity base.
Leverage is a key component to the capital structure of a company and it has a great impact on
the risk and return of the entity in question. It is divided into two main types that is operating and
financial leverage. The combination of the Two will give a third type called Total or combined
leverage. It has certain objectives as explained below;
OBJECTIVES
Leverage aims at increasing profitability without of the use of personal capital invested by the
shareholders: The objectives will include
-To Increase Profitability: Leverage is a strategy used by firms to increase their profitability
without using their personal capital invested.
-Fast Growth: The idea of leverage can help companies to grow faster when access to more
resources are provided more than their normal assets would allow.
-Generate a high return: leverage aims at generating high returns on investment than the cost
incurred to obtain loans.
Leverage has two main types which are operating and financial leverage. A combination of the
two gives us Total or Combined leverage. It is explained as follows:

OPERATING LEVERAGE
This is a type of leverage which happens when an organization or firm sustains fixed costs that
can be recovered when revenue from sales is generated no matter the size of the business at that
particular period. When a firm has fixed cost in its total costs structure, a change in the volume
of sales will lead to a disproportional change in the firm’s operating profit. Operating leverage
can be defined as the usage of fixed cost of operation to augment changes in the firm’s profits in
relation to a given change in sales volume. It is consisted of the following characteristics which
are:
Characteristics of Operating Leverage
-It is related to a firm’s fixed cost of operation
-it is highest when close to the point of breakeven of a firm
-it raises business profit at the same time creating high risks of increasing losses by the firm.
When it is high a small proportionate fall in sales will lead to a large proportionate fall in
operating profit. It is thus concerned with business risk which can be avoidable and
uncontrollable risk.
Operating leverage can be calculated using the formula:
contribution Total Revenue−Total variable cost
Operating leverage = or
Operating profit Contribution−¿ cost

NOTE:
-When contributions obtained surpasses total fixed costs it implies that it is favourable
-when contributions obtained are below total fixed costs, it implies that the situation is
unfavorable.
The degree of operating leverage can be gotten using two sales level results. It is given as
% change∈Operating Profit (EBIT )
Degree of Leverage=
% change∈ sales(Total revenue)
Example
Given that the current sales level stands at 18,000frs and breakeven point sales stands at 12,000
units, What would be the degree of operating leverage?
18,000 frs
D.O.L= =1.5
12000units
FINACIAL LEVERAGE
The capital structure of firms is composed of two categories of cost which are fixed costs capital
and variable cost capital. When fixed cost capital exists in a firm’s capital structure, it implies
that the firm has financial leverage present. Financial leverage can be thus defined as a firm’s
ability to use its fixed cost capital to enlarge or enhance the effects of changes in its operating
profit (EBIT). It has the following characteristics;
Characteristics of Financial Leverage
-It is related to fixed costs of the company
-it is classified under liabilities on the firm’s Balance sheet where different sources of capital are
classified
-it shows the effect a change in the firm’s fixed charges has on the firm’s Earnings per share
(EPS).
-When financial leverage exists in firms, the firm’s financial risk also increases. It focuses on
financial risk which can be avoidable and controllable risk.
NOTE
-When fixed cost is more than variable costs, the firm will have a high financial leverage
-When variable cost is more than fixed costs, the firm will have a low financial leverage.
Firms are advised to make use of fixed costs capital when their earnings rates are higher than
their loan capital. When the earnings rates are low the firm should use more of its ordinary shares
or equity capital.
When cost incurred to obtain loan capital is less than the overall return on capital, it is said to be
favorable financial leverage
When the cost is more than the overall return, it is said to be an unfavorable financial leverage.
Financial leverage is calculated using the formula;
EBIT
EBIT (Operatin Profit) EBIT
Financial Leverage = or or pref dividend
EBIT−I EBT EBIT−I −
1−tax rate
The Degree of financial leverage is calculated using;
% change∈ EPS % change∈ EBT
DFL= or
% change∈ EBIT (operating Profit ) % change∈ EBIT (operating Profit )

TOTAL LEVERAGE
It is also known as combined/composite leverage or super leverage. This is a leverage that is
computed with a combined effect of fixed operating cost and fixed financial costs. Firms in
competition will prefer a high level of degree of total leverage. Conservative firms (firms that
take caution when investing or taking risks) are risks adverse and will choose lower level of
degree of combined leverage. When using operating and financial leverage, a little change in
sales is magnified into a large change in earnings per share. Total leverage can be calculated
using;
contribution contribution EBIT
Total leverage = or x or Operating Leverage x Financial
EBT EBIT EBT
Leverage

% change∈ EPS % change∈ EBIT

Degree of Combined Leverage = x
% change∈ EBIT % change∈ sales

Example
CHUKUCHUKU Ltd produces and sells 100,000 units at present. Other informations are as
follows;
- 140,000frs Equity Shares at 100frs each 14,000,000frs
- 20,000 10% debentures at 1,000frs 20,000,000frs
Selling price of the product 200frs per unit
Fixed Operating Cost 2,000,000frs per year
Variable Operating Costs 100frs per unit
The rate of income tax for the company is 30%
Required:
a) Calculate OL, FL and CL in existing situation
b) Calculate the degree of OL, FL and CL if sales increases to 120,000 units and decreases
to 80,000 units
Solution:
Particulars Existing Situation Situation 1 (120,000) Situation 2: (80,000)
Sales at 200frs per 10,000,000 24,000,000 16,000,000
unit
Less: Variable cost 5,000,000 12,000,000 8,000,000
at 100frs per unit
Contribution 5,000,000 12,000,000 8,000,000
Less: Fixed costs 2,000,000 2,000,000 2,000,000
EBIT (Operating 3,000,000 10,000,000 6,000,000
Profit)
Less: Interest 2,000,000 2,000,000 2,000,000
EBT 1,000,000 8,000,000 4,000,000
Less: Income Tax 300,000 2,400,000 1,200,000
30%
EAT 700,000 5,600,000 2,800,000
Divide by number of 140,000 140,000 140,000
ordinary shares
EPS 7 40 20

In Existing Situation:
contribution 5,000,000
-Operating Leverage = = = 1.67
EBIT (Operating Profit) 3,000,000

EBIT 3,000,000
-Finance Leverage = = =3
EBT 1,000,000

contribution 5,000,000
-Combined Leverage = = = 5
EBT 1,000,000

Or Operating Leverage x Financial leverage

1.67 x 3 = 5
Degree of Operating leverage, Financing Leverage and Combined Leverage when sales increases
by 120,000units.
% change∈ EBIT (Operating Profit )
Degree of leverage =
% change∈ sales

10,000,000−3,000,000 100
= x = 70%
10,000,000 1

24,000,000−10,000,000 100
= x = 58.3%
24,000,000 1

70 %
= = 1.2 (Favorable)
58.3 %
 % change∈ EPS
Degree of Financial leverage =
% change∈ EBIT

40−7
= x 100 = 82.5%
40

10,000,000−3,000,000 100
= x = 70%
10,000,000 1
82 ,8 %
= = 1.18 (favorable)
70 %
% change∈ EPS
Degree of Combined Leverage =
% change∈ sales

40−7
= x 100 = 82.5%
40

24,000,000−10,000,000 100
= x = 58.3%
24,000,000 1

82.5 %
= = 1.42% (favorable)
58.3 %

Cash Flow Ability to Service Debts

It is also known as cash flow available for servicing debts (CFADs). It is the measure of how
much cash a business has available to pay or settle its debts after taxes, capital expenses and
operating expenses have been deducted. A company’s ability to service its debts is a key factor
used to raise capital or to enable the company to easily secure a bank loan from a financial
institution. Whenever we talk of debts, the company needs to know its ability to be able to settle
its debts. It is calculated once the following has been deducted;
- Operating Expenses
They are costs incurred to run a business such as rent, rates, salaries, transport, and
insurance.
- Taxes
Compulsory payments made to the government of a country by its citizens to enable her
take care of her expenses
- Capital Expenditure
It is money spent to purchase and maintain assets such as land, buildings, and
equipments.
- Working Capital Changes
It shows how the firm’s capital changes in areas such as accounts payable and
receivables, inventory.
Cash Flow Ability to Service Debts is important because it helps the company to critically assess
its ability to service its debts. Banks, prospective investors would prefer it over Earnings before
interest, taxes, depreciation and amortization (EBITDA) since it provides an accurate measure of
the firm’s ability to pay its loan obligations. A strong CFADs ratio implies that the firm is mostly
likely to be able to repay a loan they are requesting for.

Other Methods of Analyzing Leverage

Leverage of a company can be analyzed using several analysis tools such as Debt to Asset ratio,
Debt to capital Ratio, interest coverage ratio and consumer leverage ratio.

Debt to Asset Ratio

This is the ratio which shows a firm’s debts (loans) in relation to the firm’s assets. It can be
calculated using the formula;
debt
Debt to Asset ratio =
total asset

Debt to Equity Ratio

it shows a company’s loans in relation to the company’s shareholder equity ( ordinary shares). It
is calculated using the formula;
Debt (loans)
Debt to equity ratio =
Total Equities

Debt to Capital Ratio

It shows the company’s loans in relation to total debts plus total equity. It is calculated by
dividing debts by total equity
debts
Debt to capital ratio =
debts+total equity

Interest Coverage Ratio

It measures the company’s ability to meet its financial obligations and pay its debts

Consumer Leverage Ratio

It measures the total amount of loan an average consumer has in relation to their disporsable
income

Key Learning Points

From the study of leverage we can learn of the following points;
- Risks
Leverage increases gains and can as well lead to losses. Entrepreneurs must be aware of
the fact that potential risks and implications will develop when using leverage
- Strategy
 Strong leverage methods will involve setting clear goals and putting into practice risk
management.
- Regulation
The limits of leverage vary from country to country and market
- Obligation
Leverage brings about obligations such as covering for business losses using ones
personal funds to prevent failures
- Diversification
Leverage makes it possible for investors to diversify their finance sources such as
borrowing to invest
- Benefits
Leverage allows traders to earn larger profits compared to when they make use of only
their capital alone.

Problems Using Leverage

Leverage may bring about certain problems to the firm which will include;
- Higher Loss Potential
It can result to losses that can be greater than the initial amount invested by the firm ot
business
- Financial benefits
Leverage may lead to high loan levels which can lead the firm to financial burdens
mostly when investments don’t bring returns that were anticipated.
- Risks Return Trade Off
This will be disadvantageous because when earnings falls, debenture holders must be
paid interest and this may lead to shareholders losing their money.
REFERENCES
Youtube channel – Accounts with CHIRAG
British Business Bank