OVERVIEW OF LEVERAGE CONCEPT’S AND MODULES OF FINANCIAL MANAGEMENT

OVERVIEW OF LEVERAGE CONCEPT’S AND MODULES FINANCIAL MANAGEMENT

                                                              CONTENTS

OVERVIEW OF LEVERAGE CONCEPT’S AND MODULES OF FINANCIAL MANAGEMENT

OVERVIEW OF LEVERAGE CONCEPT’S AND MODULES FINANCIAL MANAGEMENT

Abstract:

The chapter has been described the main focus of the leverage concepts and detailed others aims at determining the type of funds a firm be supposed to seek to fiancé its funds prospect and the propionate in which these funds should be raised. The finance otherwise assets formation choice be of great and the worth intended meant for the managing on given that it authority the money owing fairness corporation affect revisit an possibility. Within proportion of owned capital has been increased the stature of firm, the return and risk shareholders resolve be far above the ground. On other hand owned capital an debt capital also is more in the total capital of the firm, the go back as fine as danger of the shareholders will be much less than. Leverage concepts and techniques use by business firms to much less quantity of risk retune relationship of afferent alternative of capital strut rue can be identified in the leverage management focus in the structure.

Keywords: Leverages, Operating Leverage, Financial Leverage, Combined Leverage.

Introduction:

Leverage outcome from the use of assets or capital on money to raise the income to the owners of the company. In the main increased in force consequences in better income along with threat and decrease in control outcome in reduce in income and risk. The sum of influence in the firm’s assets development the combine of long-standing balance due is able to a lot affect its worth by moving of returns. In view of the fact so hence the capacity of sales has been change in leverage helps in quantify such control. It may consequently be distinct as relations alter in income due to a makeover in sale. A far above the ground implies that there will be a large change in profits due to moderately little change in sales and vice-versa thus, the influence the advanced is the menace and upper is the predictable return. Finally  this leverage concepts is effectively in using firms and the backbone of the financial sectors to be fulfilled in the trade and equity of the shareholders.

The word ‘leverage’ in universal refers in the direction of an association connecting two consistent erratic. Inside monetary study, it represent the control of one financial erratic in excess of a number of other connected monetary not constant.

The three essential type of influence leverage modules can be clear suggestion to firm’s returns while follow:

1. The tendency of the operating profit to the vary disproportionately with sales
2. The financial leverage may defined has incredible of the outstanding net income to vary excessively with in service Earnings

.3.Composite leverage thus expenses the connection of on account of sales and taxable income contribute to the sales less and variable cost and the taxable income leverage.

Meaning of leverage:

The phrase leverage refers to an enlarged means of accomplish some purpose. For example, leverage helps us in exciting heavy objects, which may not be or else possible. On the other hand in the area of fiancé, the term influence has a special meaning. It is used to explain the firm’s aptitude to use fixed cost resources or funds to expand the return to its owner.

Definition of Leverage:

James Horne: Leverage is the service of assets otherwise funds for which the firm pays a set cost or rigid of the return.

Ezra Soloman: It refers to the service of an resources or funds for the firm pays a fixed cost and fixed returns.

S.C.Kuchhal: Leverage refers toward meeting a fixed cost or playing a fixed extern for employing resources or funds.

The definition given below is indicated that fixe cost or return is the fulcrum of leverage. Leverage is the result of the employment of an assets or funds having a flat rate or revisit. The former may be termed as fixed operating cost whereas the concluding may be termed as fixed financial cost. As fixed cost or return has to be paid irrespective of the volume of production or sales, it has significant authority on the amount of profit available for the equity. This definition is really help to upcoming sum modules and techniques realized in the operating and financial leverage can be raised in the outcome of basis in the rate of return to the shareholders. The former may be fixed operating cost and while the latter has termed in the fixed financial cost it has been should be noted that fixe cost to return in the leverage. the firm is not required to pay that fixed cost return in there be no leverage.

Review of literature:

The word ‘Leverage’ sound like it has a optimistic ring to it. But the reality is as diverse as chalk from cheese. It has its pros under a exacting set of financial state of affairs in addition to also its cons in a diverse set of action and monetary situation. Financial Leverage has for eternity been a ideal issue with the dealing group of people. It evokes a full gamut of response on or after both the instruction group of people and the dealing area. To wholly determine this assortment of judgment and remains of work, several books, journals and articles were reviewed to undertake theoretical study of operating leverage and Financial Leverage and also combined leverages under together studies.

1. Baker (1973) analyzes that effect of financial leverage or moderately greater use of debt capital, on industry profitability. This study has been tested a model consisting of two equations, one explanation industry profitability in terms of the usual market as well as structure variables plus leverage and the other one was a new equation incorporating risk variables to explain leverage. Now a day is preferred to the how to equity in the monetary routine overcome to utmost. He measured inversely as the ratio of equity to total assets for the leading firms in an industry over ten years. First he used two stages least square process of judgment which shows leverage is significant and has the theoretically correct negative sign which means low amounts of leverage tend to raise industry profit raises. Secondly he used ordinary least square estimation which also indorsed the same results.
2. Doron Nissim and Stephen Penman (2001) contain tried to analysis the optimistic and adverse impact of leverage on the profusion of various values. The credentials also distinguish the wealth of operation from the profitability of Financing Activities. The term paper outlines the arithmetical equations and derivation on the topic of the blow of financial leverage on the shareholders’ effectiveness. The author has also on hand the impact that financial leverage has on the shareholders’ value. The authors have for a short time declared the age-old theory of assets structure such as the pecking order theory or long-established trade-off theory etc. the paper goes on to analyze the investor efficiency that arise from operation and it also differentiate such profitability from that which arises from borrow to finance operations. The term paper presents a financial statement study that identify the personal property of finance liability on rates of return on book value with explicit leveraging equations that explain when the force is favorable and when poor with the help of a case of Dell Computers, USA. The authors have expanded the perception of leverage from very basics to its involved impact on the success and the arithmetical presentation of the same.
3. Khushbakht Tayyaba, in a research paper titled, “Leverage” – Analysis and Its force On effectiveness With Reference To Selected Oil And Gas Companies, in July 2013, has studied the effect of influence on the achievement of the oil and gas sector. The shows the association between leverage concepts of (Financial, operating and combined) and Earning per Share (EPS) of this sector. It also shows the connection between the Debt equity ratio and Earning per Share (EPS) and how this sector does debt financing efficiently. In this paper, oil and gas companies are selected for analysis and hypotheses are examine with the balanced panel by means of descriptive statistics, correlation and estimate equation.

4.Syed Shah Fasih Ur Rehman in a research paper titled, The “association between Financial Leverage and Financial Performance: Empirical Evidence of Listed Sugar Companies of Pakistan8”, in 2013, has  investigate the power of fiscal leverage on financial performance and whether financial leverage has an outcome on monetary act by taking facts from planned sugar companies of Pakistan. The results of the study show the mix results. The results show the positive opinion of debt equity ratio with return on asset and sales augmentation, and negative association of debt equity ratio with earn per share, net profit edge and return on equity. Finally the leverage classify the three components has been go through to set the all variable to be applied in the leverage concepts of focus in the research paper.

5. D. Vijaya lakshmi and Padmaja Manoharan in a research paper titled, “Determinants of leverage -An Empirical analysis on Indian metal sector15”, make out and examine the determinants of influence of Indian metal sector. A panel data move toward has been useful to investigate the information. The learn reveals that the variables, namely, effectiveness, size and tangibility are the key determinants of leverage of Indian metal sector
6. McClure et al. (1999) found that companies’ capital structure are still considerably diverse by people for the G7 countries (Canada, France, Italy, US, Germany, Japan, UK), and suggested that macroeconomic factors, including profitable growth, interest rates and inflation, may be important considerations in capital structure decisions and cause of difference.
7. Stenbacka and Tombak (2002) argue that both capital structure and reserves are endogenous and that they both depend on more basic ingredient such as the nature of the capital markets, the characteristics of speculation opportunity available to the firm, and the internal funds. They showed that the optimal combination of debt and equity depends on a trade off between the bankruptcy risk associated with debt and the dilution cost of incumbent shareholders of new equity Finally the study risk is low about the performance of the leverage hihly profitable income in the growth of the sector to be concern.

Types of leverages modules:

1. Operating Leverage:

Meaning

Operating leverage implies use of fixed cost in the operation of a firm. As pointed out earlier, every firm has to incur fixed cost irrespective of the volume of production or sales. Since fixed cost remain cost, even a small changes in sales brings about more than proportionate changes in operating profit. This occurrence is termed as in use force. It thus defined as the firm capability to use set working charge to magnify the possessions during sale on its earnings before interest and taxes EBIT. It can be applying the following formula:

Operating leverage = Contribution

                                         EBIT

Where, Contribution = sales – variable cost.

EBIT = Operating profit.

It may be mentioned here that operating leverage may be favorable or unfavorable. Favorable operating leverage arises when contribution exceeds fixed cost and vice versa in the opposite case.

Degree of operating Leverage:

Degree of operating leverage DOL represent change in the operating profits resulting from a percentage the transform in the sales. It may be put in the outline of following equation.

DOL =    % change in EBIT

                                     % change in sales

The amount of in use influence depends upon the amount of fixed cost elements in the cost structure. A firm is said to have a elevated degree of operating leverage if it employ a greater amount of fixed cost and a less significant sum of up-and-down cost. On the country if the

Firm incurs a greater amount of fixed cost it products a low degree of in use leverage.

Illustration: 1

X Ltd sells 1,000 units @ Rs.20 per unit. The cost of production is Rs. 14 per unit. The firm has a fixed cost of rs. 2000. Assume that the sales of x ltd increase by 50%. The present an expected cost and profit would be as follows:

Present                                     Expected

Rs                                             Rs

Sales                     (1,000×20)                  20,000                 (1,500×20)                 30,000

Less: variable cost      (1,000×14)                    14,000                 (1,500×14)                  21000

Contribution                                                 6,000                                                    9,000

Less: Fixed cost                                                   2,000                                                    2,000

Operating Profit (EBIT)                             4,000                                                    7,000

DOL=        % change in EBIT

% increase in sales

Percentage change in EBIT = 3000   x 100   = 75%

4,000

Percentage increase in sales = 10,000 x 100    = 50%

20,000

DOL= 75%     = 1.5

50%

The extent of in use leverage is 1.5 incomes that 1% increase in sales would consequence in 1.5% increase in in service profit. In the above example proportion increase in operating profit is 75% and percentage add to in sales is 50%. It resources that for each enlarge of 1% in sales level, the proportion increase in use profit would be 1.5.

A firm will not include an in use of leverage if there is no rigid charge and the total cost is changeable in nature. In such belongings the operating profit varies in straight amount to the change in sale step. This is illustrated.

Sales                     (1,000×20)                  20,000                 (1,500×20)                 30,000

Less: variable cost      (1,000×14)                    14,000                 (1,500×14)                  21000

Contribution                                                 6,000                                                    9,000

DOL=        %change in Earnings before interest tax EBIT

% increase in sales

Percentage change in EBIT = 3000   x 100   = 50%

6,000

Percentage increase in sales =   10,000 x 100    = 50%

20,000

DOL= 50%     = 1

50%

The degree of operating leverage of 1 mean that increase in profit 50% in this example is in direct proportion to increase in sales 50% in this example.

Significance of operating leverage:

The study of operating leverage of a rigid is very useful to the fiancé manager. It tells the impact of change in sales on operating income. A firm having higher DOL can experience a magnified effect on EBIT for even small changes in sales level. Higher DOL can dramatically increase the operating profit bit if there is decline in sales level EBIT mat be  has concern in that part of wiped out and a loss may be operated. As indicated earlier the operating leverage has deepens upon the fixed cost .if the fixed cost is higher the firms operating leverage and its operating leverage risks. If operating leverage is high it automatically means that the breakeven point would also be reached at a high level of sales. And also in such cases been determined in the higher operating leverage sufficiently above that break has to avoid in the danger of the fluctuate in sales an profits of the operating leverage.

2. Financial leverage:

Meaning

The financial leverage may be defined as the tendency of the residual net income to vary disproportionately with operating profit. It indicates the change that takes place in the taxable income as a result of change in the operating income. It signifies the existence of fixe interest and fixed dividend bearing securities in the total capital structure of the company. These charges have to pay regardless

of the amount of EBIT these charges include to be paid not considering of the amount of EBIT available to pay them. Therefore paying them the remaining EBIT belongs to equity to equity shareholders. Financial leverage is concerned with the effect of change in EBIT on the earning available to equity the shareholders EPS. As a ability of the firm to use financial leverage EBIT earning per share is the financial leverage.

Favorable and unfavorable Financial leverage:

Financial leverage may be favorable and or unfavorable opening upon earnings made by the use of fixed interest or dividend bearing securities exceeds or not explicit fixe cost. the leverage will be considered to be favorable so long the firm earn more on assists purchased with the funds than the fixed cost of their use. Unfavorable or negative leverage occurs when the firm does not earn as much as the funds costs.

Trading on equity and financial leverage:

The Financial leverage is also from time to time term as trading on equity. But most of the author on financial management are of the estimation that the expression trading on equity be supposed to be used for the term financial leverage only when the fiscal influence is favorable. For example: if a company borrows Rs 100 at 8% interest per annum, and earn a return of 12% the balance of rs.4 per annum behind sum of interest will belong to the shareholders and thus they can be paid a advanced rate of go again than the general rate of earning of the company. But in case earn a return of only 6% on Rs.100 employed by it the equity shareholders loss would be Rs.2 per annum.

Computation

The computation of financial leverage can be done according to the following methods:

(i) Where capital structure consists of equity shares and debt. In such a case financial leverage can be calculated according to the following formula

Financial leverage = EBIT

                                    EBT

Where,

EBIT= Earnings before interest tax

EBT = Earnings before tax

Degree of financial leverage

The degree of financial leverage (DFL) is the percentage change in taxable profit of percentage change in operating profit, i.e., the ability of the firm to utilize fixed financial costs in order to magnify the effect of changes in EBIT on EPS of the fiend

DFL =              % change in Earning per share

% change in Earnings before interest tax EBIT

Illustration: 2

The capital structure of Grace Ltd. Consists of equity share capital of Rs.8, 00,000 (shares of Rs. 100 each) and Rs.8, 00,000 of 12% debentures. Sales have increased from 80,000 units to 1, 20,000 units the selling price is Rs. 15 per unit, variable cost amount to rs.9 per unit and fixed cost amounts to Rs.1,60,000. The income tax rate is assumed to be 50%.

Required:

• Calculate the percentage increase in EPS
• Determine operating leverage at 80,000 units and 1,20,000 units
• Determine financial leverage at 80,000 units an 1,20,000 units.

Comment on the risk position of the company.

Solution:

                                         PROFITABLITY STATEMENT

• Percentage increase in EPS = 29-14    x 100  = 107.14%

14

• Operating leverage: Contribution

EBIT

For 80,000 units                           4, 80,000   = 1.5 times

3, 20,000

For 1, 20,000 units                   7, 20,000   = 1.28 times

5, 60,000

Financial leverage =      EBIT

EBT

For 80,000 units                         = 3, 20,000   = 1.43 times

2, 24,000

For 1, 20,000 units                    = 5, 60,000 = 1.20 times

4, 64,000

Analysis: Due to increase in sales from 80,000 units to 1,20,000, EPs has risen by 107.14%, while operating leverage has come down from 1.5 times to 1.28 times and financial leverage  has declined from 1.43 times to 1.28 times. Hence there is a fall in both business risk and financial risk. This happen when there is corresponding increase in fixed cost.

3. Combined leverage:

As explained above operating measures percentage change in operating profit as a result of percentage change in sales and financial leverage measures percentage change in taxable profit or EPS due to percentage change in operating profit. Whereas operating leverage indicated the degree of operating risk an financial risk indicated the amount of monetary risk. Both these influence are intimately troubled with the firm’s ability to meet its set costs both in service and monetary. Incase both the influence are mutual the result obtain will reveal the outcome of transform in sales over change in sales. This can be computed as follows:

Combined thus establishes relationship between sales i.e, contribution and the corresponding variation in taxation income. It can be computed by adopting the follow:

Combined Leverage: operating leverage x financial leverage

= contribution x   EBIT

EBIT                EBT

= contribution

EBT

The computation of mutual composite control is able to be explained with the help of the following example.

Illustration: 3

Jeffi Ltd has sales of Rs. 5, 00,000. The variable cost is 60% of the sales and fixed cost is Rs.80, 000. The interest on debenture is Rs.80, 000 compute the combined leverage and show the impact of taxable income when sales increase by 5%.

Solution:

                                Statement showing Taxable income

Rs

Sales                                                 5, 00,000

Less: Variable cost                                       3, 00,000

(3, 00,000×60%)

Contribution                                                 2, 00,000

Less: Fixed cost                                            80,000

EBIT                                                             1, 20,000

Less: Interest on debenture                          80,000

EBT                                                  40,000

Combine Interest Leverage: Contribution    2, 00,000      = 5

EBT                40,000

Composite leverage of 3tells that whenever the sales increase by Rs.2, the taxable income also increase by Rs.3. (1×3). This can be verified by the following computation when the sales increase by 5%.

          Statement showing Taxable income (sales increase 5%)

Rs

Sales (5, 00,000×105%)                    5, 25,000

Less: Variable cost                                       3, 15,000

(5, 25,000×60%)

Contribution                                                 2, 10,000

Less: Fixed cost                                            80,000

EBIT                                                             1, 30,000

Less: Interest on debenture                          80,000

EBT                                                  50,000

Increase in percentage of profit = Increase in profit       x 100

Base profit

= 10,000 x 100 = 25%

40,000

It is clear about the calculation that on account of increase is sales by 5% the EBT has increased by 25%.

Significance of combined Leverage:

The ratio of contribution to earnings before tax given by combined leverage shows the combined effects of financial and operating leverages. A far above the ground operating leverage and a high financial leverage mixture is very risky. If the firm is produce and selling at high level it will make tremendously high proceeds for its shareholders. But even a small fall in the level of operation would result in a tremendous fall in earnings per share. A firm must therefore maintain a proper balance between these two leverages.

It is a combination of both operating and financial leverage. It expresses the effect of change in sales over change in taxable profit. Though a more preferable has been the state of affairs would be to have a little in use force and a high financial leverage. A low operating leverage would by design imply that the firm reaches its break – even point at a low level of sales. Therefore risk is diminish has highly a conservative manger will keep both operating and financial influence at very low levels. This move toward may however mean that the firm is losing its money-making opportunity.

FINANCIAL BREAK –EVEM POINT:

Meaning

It may be defined as that level of earnings before interest and tax (EBIT) at which a firm will be in a position to satisfy all fixed financial charges i.e., interest and preference dividend. It may be noted that since preference dividend is not deductible as an expense for tax purpose, the amount of dividend will therefore have to be grossed up. For instance if the interest is Rs. 40,000 amount of preference divined is Rs.25,000 and the tax rate is 35%, the amount of EBIT for financial break-even point will be:

EBIT = Rs.40, 000 + Rs.25, 000 / 0.65

= Rs.40, 000 + Rs.38, 462

= Rs.78, 462

The formula for calculating the financial break-even point can be put as under:

Financial Break-even point = I +    DP

1-t

Where:

I = Interest

DP= Dividend preference share

T = Tax rate

In case the earnings before interest and tax is less than that requirement for financial break-even the earning per share EPS will be negative. At financial break-even point the profits available for equity shareholders for equity shareholders will be zero and therefore EPS will also be zero. Any increase in the level of earning beyond financial point will result in increase in EPS more than proportionate to increase in EBIT.

Illustration: 4 .The following have been given in respect of Grace co Ltd:

Output                                                   5, 00,000 units

Fixed cost Rs                                         5, 00,000

Unit variable cost Re                             1

Interest expense Rs                               2, 75,000

Unit selling price (Rs)                            3

On the basis of above information calculate a) Operating leverage B) Financial leverage c) operating breakeven point d) financial breakeven point

Solution:                                Statement of profit

Sales    (5, 00,000 x3)              15, 00,000

Less: Variable cost

(5, 00,000x 1)                           5, 00,000

Contribution                 10, 00,000

Less: fixed cost                          5,00,000

EBIT                            5, 00,000

Less: Entreat on Debt              2, 75,000

EBT                              2, 25,000

1. Operating leverage: Contribution / EBIT = 10,00,000/5,00,000 = 2 times
2. Financial leverage: EBIT/EBT = 5,00,000/2,25,000 = 2.23 times
3. Operating BEP = Fixed cost / contribution = 5,00,000/ 2 = 2,50,000 units
4. Financial leverage: Fixed cost/ contribution x sales = 5,00,000/10,00,000 x 15,00,000

Rs = 7, 50,000

Conclusion:

The result of financial leverage depends upon on the firm’s Earnings before interest tax.. When EBIT is moderately far above the ground, leverage is valuable. Shareholders are showing to further threat underneath the planned resources arrangement given that the EPS and ROE are a good deal more responsive to transform in Earnings before interest tax. We may now about that finally conclude this leverage studies as in a general sense lever is used to achieve and certain object which is otherwise not possible. Similarly in corporate fiancé it helps in providing the total risk profile of the firm and in achieving the magnified result has been of a very less effort or change.

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