Submitted By:
Samarth Gupta
18MBAIB14
Financial Management
PSMBAIBTC0204
International Centre for Cross
Cultural Research & Human
Resource Management

What is Leverage?
 In general terms, leverage means the use of force
and effects to produce a more than normal results
from a given action
 In other words, leverage is the advantage generated
by using a lever
 Example, using a jack to lift a car
 In Finance, leverage is the use of fixed costs to
magnify the potential return to a firm
 2 types of fixed costs:
 fixed operating costs = rent, salaries, etc.
 fixed financial costs = interest costs from debt

What is Leverage?
 Leverage can magnify returns to common stockholders but can
also increase risk
 Management has almost complete control over this risk
introduced through the use of leverage (fixed costs)
 The degree in the use of leverage depends on management’s
attitude toward risk and the nature of its business, among
others.
 Three types of leverage with reference to the firm’s income
statement:
 Operating leverage,
 Financial leverage, and
 Combined (Total) leverage.
 Leverage is measured on the profitability range of operations.

What is Leverage?
Sales
Less: Total variable Costs
Contribution Margin
Less: Fixed Cost
Earnings Before Interest and Taxes (EBIT)
Less: Interest
Earnings Before Taxes
Less: Taxes
Earnings After Taxes (EAT)
Number of Shares Outstanding
Earnings Per Share
Operating
leverage
Financial
leverage

Operating Leverage
 The use of fixed operating
costs as opposed to variable
operating costs.
 A firm with relatively high
fixed operating costs will
experience more variable
operating income if sales
change.

Degree of Operating
Leverage (DOL)
 Operating leverage: by using
fixed operating costs, a small
change in sales revenue is
magnified into a larger change in
operating income.
 This “multiplier effect” is called
the degree of operating leverage.

DOLs = % change in EBIT
% change in sales
change in EBIT
EBIT
change in sales
sales
=
Degree of Operating Leverage
from Sales Level (S)

 If we have the data, we can use this formula:
Degree of Operating Leverage
from Sales Level (S)
DOLs =
Sales - Variable Costs
EBIT

Financial
Leverage
 The use of fixed-cost sources
of financing (debt, preferred
stock) rather than variable-
cost sources (common
stock).

Financial Risk
 The variability or uncertainty of
a firm’s earnings per share
(EPS) and the increased
probability of insolvency that
arises when a firm uses financial
leverage.
FIRMEBIT EPS
Stock-
holders

Degree of Financial
Leverage (DFL)
 Financial leverage: by using
fixed cost financing, a small
change in operating income is
magnified into a larger change
in earnings per share.
 This “multiplier effect” is called
the degree of financial
leverage.

DFL = % change in EPS
% change in EBIT
change in EPS
EPS
change in EBIT
EBIT
Degree of Financial
Leverage
=

Degree of Financial
Leverage
 If we have the data, we can use this
formula:
DFL = EBIT
EBIT - I

What does this tell us?
 If DFL = 3, then a 1% increase in
operating income will result in a
3% increase in earnings per share.
Stock-
holdersEBIT EPSSales

Based on the following information on
Levered Company, let us try to answer
these questions:
1) If sales increase by 10%, what should
happen to operating income?
2) If operating income increases by 10%,
what should happen to EPS?

Levered Company
Sales (100,000 units) $1,400,000
Variable Costs $800,000
Fixed Costs $250,000
Interest paid $125,000
Tax rate 34%
Common shares outstanding 100,000

EPS
Financial
leverage
Operating
Income
Sales
Operating
leverage
Levered Company

Degree of Operating
Leverage from Sales Level (S)
1,400,000 - 800,000
350,000
= 1.714
=
DOLs =
Sales - Variable Costs
EBIT

EPS
Operating
Income
Sales
Operating
leverage
10%
17.14%
Levered Company

Degree of Financial
Leverage
DFL = EBIT
EBIT - I
= 350,000
225,000
= 1.556

EPS
Financial
leverage
Operating
Income
Sales
10%
15.56%
Levered
Company

Sales (110,000 units) 1,540,000
Variable Costs (880,000)
Fixed Costs (250,000)
EBIT 410,000 ( +17.14%)
Interest (125,000)
EBT 285,000 (+26.67%)
Taxes (34%) (96,900)
Net Income 188,100
EPS $1.881 ( +26.67%)
Levered Company
10% increase in sales