Amity business school

1. Amity Business School
1
Amity Business School
Semester II
FINANCIAL MANAGEMENT
Module (Leverage Analysis)

2. Amity Business School
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).

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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

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EBIT%Δ
PSE%Δ
DFL =
Degree of Financial Leverage (DFL)
EPS
•The degree of financial leverage (DFL) can be
calculated as:
eentVariablinIndepend
tVariableinDependen
∆
∆
%
%
=

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•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).

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Therefore Financial leverage can be written as-
EBIT
Financial Leverage =
EBT
EBT = EBIT- Interest
EBT is also called PBT

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Whenever, 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%Δ
DFL =
EPS
EBIT
Financial Leverage =
EBT – (Preference Dividend)
(1-tax rate)

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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%

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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%

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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%Δ
DFL =
EPS

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•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.

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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.

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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%

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2.03,
40%
81.25%
DFL =
+
+
=

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•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

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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

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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)

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•
Sales (total revenue) (80,000 units @ $2) $160,000
— Fixed costs 60,000
— Variable costs ($0.80 per unit) 64,000
Operating income $ 36,000
Earnings before interest and taxes $ 36,000
— Interest 12,000
Earnings before taxes 24,000
— Taxes 12,000
Earnings after taxes $ 12,000
Shares 8,000
Earnings per share $1.50
Operating
leverage
Financial
leverage

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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.

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• 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.

21. Amity Business School
Master Table to Calculate the Leverage
Sales
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

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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.