Question

A8. What is meant by the term leverage? How do operating leverage, financial leverage, and total leverage relate to the income statement?

Answer 1

Leverage: The term leverage represents influence or power. In financial analysis leverage represents the influence of one financial variable over some other related financial variable. These financial variables may be costs, output, sales revenue, Earnings Before Interest and Tax (EBIT), Earning per share (EPS) etc.

Operating Leverage: It is the relationship between Sales and EBIT and indicates Business Risk.

Operating Leverage means tendency of operating income (EBIT) to change disproportionately with change in sale volume. This disproportionate change is caused by operating fixed cost, which does not change with change in sales volume. In other words, operating leverage (OL) maybe defined as the employment of an asset with a fixed cost so that enough revenue can be generated to cover all the fixed and variable costs.

The use of assets for which a company pays a fixed cost is called operating leverage. Operating leverage is a function of three factors:

(i) Amount of fixed cost,

(ii) Variable contribution margin, and

(iii) Volume of sales.

Operating Leverage is calculated as: Contribution / EBIT

where, EBIT = Contribution - Fixed Cost

Financial Leverage: it is the relationship between EBIT and EPS and indicates Financial Risk.

Financial leverage (FL) maybe defined as ‘the use of funds with a fixed cost in order to increase earnings per share.’ In other words, it is the use of company funds on which it pays a limited return. Financial leverage involves the use of funds obtained at a fixed cost in the hope of increasing the return to common stockholders.

Financial Leverage is calculated as: EBIT / EBT

where, EBT = EBIT - Interest

Combined Leverage: It is the relationship between Sales and EPS and indicates Total Risk (Both Business and Financial Risks).

Combined leverage maybe defined as the potential use of fixed costs, both operating and financial, which magnifies the effect of sales volume change on the earning per share of the firm.

Combined Leverage is calculated as (Operating Leverage * Financial Leverage) (or) Contribution / EBT