DEFINE AND EXPLAIN THE LEVERAGE?

Leverage: The word “leverage” is derived from the word “lever” which means to get more than normal results with the given force of action. The word leverage is used in physics, political science and in business organization.

In Physics: In physics leverage means to use of special force and effects in order to get more than normal results.

In Political Science: In political science leverage means use of special words and issues to get more than normal results.

In Business Organization: In business organization leverage means using some special forces which effect the firm company or any organization to get more than normal results.

Definition Of Leverage: The term leverage can be define in different ways. Existence of total fixed cost operating fixed cost and financial fixed cost in the firm income stream.

Types Of Leverage: Leverage can be classified on the basic of results and function.

On The Basis Of Results: On the basis of result leverage are of two types;

Favorable Leverage: Leverage is said to be favorable at high level of output.

Un-Favorable Leverage: Leverage is said to be un-favorable at low level of output.

On The Basis Of Function: On the basis of function leverage are of three types given as under;

1) Operating Leverage

2) Financial Leverage

3) Total/ Combined Leverage

v Operating Leverage: Operating leverage means use of operating fixed cost by the business firm in order to magnify the effect of change in sales on EBIT. Earning before interest and taxes. Operating leverage means the existence of operating fixed cost on firm income stream.

Features: Following are main features of operating fixed cost.

1) It exists when the firm employ operating fixed cost.

2) It shows the relationship between sales revenue and earning before interest and taxes.

3) It is first stage leverage.

Explanation: When firm employ operating fixed cost in its operating activities, then in such firm, operating leverage exists. When firm increases its operating fixed costs then it magnify its result. i.e. it increases its sale and which increases earning before interest and taxes (EBIT) and vice versa.

v Financial Leverage: Financial leverage means existence of financial fixed cost in the firm income stream. Use of financial fixed cost the business firm in order to fund its assets and to magnify the effect of EBIT on EPS.

Features: Following are the main important features of financial leverage.

1) It exists when firm employ fixed financial charges.

2) Financial leverage reflected for financing section of the firm.

3) Financial leverage starts used operating leverage ends.

4) Financial leverage shows the relationship between earning before interest and taxes (EBIT) and earning per share (EPS).

5) It is second stage leverage.

Explanation: From the above definition it is clear that when firm manager finances the firm with two sources. Debt capital and equity capital which needs fixed return or charges that in such firm financial level exists.

v Total/Combined Leverage: Total leverage means the existence of total fixed cost in the firm income stream. Total fixed cost include operating fixed cost and financial fixed cost. Use of total fixed costs by the business firms in order to magnify the effect of change in sales on EPS.

Features: Following are the main features of total financial leverage.

1) Total leverage shows the relationship between sales and EPS.

2) It causes change in sales volume to have magnified effect on the earning per share.

Explanation: It means that when firm employ both operating and financial fixed cost. Then in such firm the total leverage exists. When total leverage is present in the firm income stream then it increases EPS whatever the sale is increased.

v TOTAL LEVERAGE

Ø Operating Leverage;

· Sales Revenue

· Loss: Cost Of Good Sold

· Gross Profit

· Less: Operating Expenses

· EBIT

Ø Financial Leverage;

· Less: Interest

· Earning Before Taxes

· Less: Taxes

· Earning After Taxes

· Less: Preferred Store Dividends

· Earning Available For Common Stockholders

· Earning Per Share EPS

From the above general income statement format the upper portion represents the operating leverage. Next to upper portion represents the financial leverage and operating and financial level include in total leverage.

Measuring The Degree Of Leverage: There are three types of measure the degree of leverage which are as follows;

1) Degree Of Operating Leverage

2) Degree Of Financial Leverage

3) Degree Of Total Leverage

Now I can discuss all the above term one by one given below;

v Degree Of Operating Leverage: Degree of operating leverage is use to determine. The sensitivity of percentage change in EBIT resulting from percentage change in sales. A quantitative measure of operating leverage is known as degree of operating leverage.

· Mathematical Calculation: Mathematically we can define it as. As we know that;

· degree of operating leverage = %age change in EBIT

§ %age change in sales

· Formula Derivation: DOL = change in EBIT / change in sales

· EBIT / sales

· = del EBIT / del Q

o EBIT/Q

· We know that EBIT = TR-TO

· EBIT = QP – (TVC + TFC)

· EBIT = QP – (QVC + FC)

· = QP – QVC – FC

· = Q (P-VC) – FC

· SO, DOL = Q (P-VC)

§ Q(P-VC)- FC

· Explanation: From the above discussion it clear that whenever the percentage change in EBIT resulting from given percentage change in sales, than operating leverage exists.

v Degree Of Financial Leverage: Degree of financial leverage is used to measure the sensitivity of earning per share resulting from change in EBIT. Simply we can say its percentage change in EPS resulting from percentage change in EBIT is known as financial leverage.

· Mathematical Calculation: Mathematically we can calculate it as a;

· degree of financial leverage (DFL) = %age change in EPS

· %age change in EBIT

· Formula Derivation: DFL = %age change in EPS

o %age change in EBIT

· = change in EPS / change in EBIT

o EPS / EBIT

· = del EPS/ del EBIT

o EPS/EBIT

· DFL = EBIT

· EBIT-1

· Explanation: From the above discussion it is clear that whenever the percentage change in earning per share resulting from a given percentage change in EBIT is greater then financial leverage exists. If DFL = 1 there is no existence of interest/ financial leverage and if DFL greater then 1, there is existence of financial leverage.

v Degree Of Total Leverage: Degree of total leverage is used to determine the sensitivity of earning per share resulting from percentage change in sales. A quantitative measure of total leverage is called degree of total leverage.

· Mathematically We Calculate Total Leverage;

· Degree of total leverage = %age change EPS

o %age change EBIT

· DTL = change in EPS / change in EBIT

§ EPS / EBIT

· DTL = Q (P-V)

o Q (P-V) –F.C-T

· Or DTL = DOL multiply DFL

· Explanation: From the above discussion so, whenever the %age change in EPS resulting from a given percentage change in sales is greater than the percentage change in sales, total leverage exists. If DTL greater than 1 there is existence of total leverage and if DTL = 1 no existence of total leverage.

Ø Breakeven analysis: Breakeven analysis shows the relationship between the cost, sales and profitability of the firm.

Ø Breakeven point: It is the level of output at which the total cost equal to total revenue is known as breakeven point.

Mathematical calculation: Mathematically we can calculate it, as we know that;

TR=TC

When EBIT= 0

· EBIT= TR-TC

· EBIT= TR- (TFC+TVC)

· EBIT= P multiply Q- (TFC+VC multiply Q)

· EBIT= P multiply Q-TFC-VC multiply Q

· EBIT= P multiply Q-VC multiply Q-TFC

· EBIT= Q (P-V)-TFC

· 0= Q (P-V)-TFC