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Leverage Analysis: Operating, Financial, and Combined

Prerequisites

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1. What is Leverage?

Leverage (from the word "lever") means using a small force to lift a heavy object.

In Finance: Using fixed-cost funds (debt or fixed operating costs) to magnify the effect of changes in sales on profits.

Types:

  1. Operating Leverage (Business Risk)
  2. Financial Leverage (Financial Risk)
  3. Combined Leverage (Total Risk)

2. OPERATING LEVERAGE (DOL)

2.1 Definition

Operating Leverage measures the sensitivity of Operating Profit (EBIT) to changes in Sales.

It arises due to fixed operating costs (rent, salaries, depreciation) that don't change with sales volume.

2.2 Degree of Operating Leverage (DOL) Formula

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2.3 Interpretation

DOL = 2.5 means:

  • If sales increase by 10%, EBIT will increase by 25% (10% × 2.5)
  • If sales decrease by 10%, EBIT will decrease by 25%

Higher DOL → Higher Business Risk → Higher volatility in EBIT

2.4 Numerical Problem (Exam Format)

Problem: Calculate DOL from the following data:

Sales: ₹5,00,000
Variable Costs: ₹3,00,000
Fixed Operating Costs: ₹1,20,000

Solution:

Step 1: Calculate Contribution

Contribution = Sales - Variable Costs
Contribution = ₹5,00,000 - ₹3,00,000
Contribution = ₹2,00,000

Step 2: Calculate EBIT

EBIT = Contribution - Fixed Costs
EBIT = ₹2,00,000 - ₹1,20,000
EBIT = ₹80,000

Step 3: Calculate DOL

DOL = Contribution / EBIT
DOL = ₹2,00,000 / ₹80,000
DOL = 2.5

Answer: Degree of Operating Leverage is 2.5.

Interpretation: A 10% change in sales will cause a 25% change in EBIT.

3. FINANCIAL LEVERAGE (DFL)

3.1 Definition

Financial Leverage measures the sensitivity of Earnings Per Share (EPS) to changes in Operating Profit (EBIT).

It arises due to fixed financial costs (interest on debt, preference dividend).

3.2 Degree of Financial Leverage (DFL) Formula

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3.3 Interpretation

DFL = 1.5 means:

  • If EBIT increases by 10%, EPS will increase by 15% (10% × 1.5)
  • If EBIT decreases by 10%, EPS will decrease by 15%

Higher DFL → Higher Financial Risk → Higher volatility in EPS

3.4 Numerical Problem (Exam Format)

Problem: Calculate DFL from the following:

EBIT: ₹2,00,000
Interest on Debt: ₹50,000
Tax Rate: 30%

Solution:

Step 1: Apply DFL Formula

DFL = EBIT / (EBIT - Interest)
DFL = ₹2,00,000 / (₹2,00,000 - ₹50,000)
DFL = ₹2,00,000 / ₹1,50,000
DFL = 1.33

Answer: Degree of Financial Leverage is 1.33.

Interpretation: A 10% change in EBIT will cause a 13.3% change in EPS.

4. COMBINED LEVERAGE (DCL)

4.1 Definition

Combined Leverage measures the total effect of both operating and financial leverage - the sensitivity of EPS to changes in Sales.

4.2 Degree of Combined Leverage (DCL) Formula

DCL Formula

DCL = DOL × DFL

OR

DCL = % Change in EPS / % Change in Sales

OR

DCL = Contribution / (EBIT - Interest)

4.3 Interpretation

DCL = 4 means:

  • If sales increase by 10%, EPS will increase by 40% (10% × 4)
  • Combines both business and financial risk

4.4 Numerical Problem (Exam Format)

Problem: Calculate DCL using the following data:

Sales: ₹10,00,000
Variable Costs: ₹6,00,000
Fixed Operating Costs: ₹2,00,000
Interest: ₹80,000

Solution:

Step 1: Calculate Contribution

Contribution = Sales - Variable Costs
Contribution = ₹10,00,000 - ₹6,00,000
Contribution = ₹4,00,000

Step 2: Calculate EBIT

EBIT = Contribution - Fixed Costs
EBIT = ₹4,00,000 - ₹2,00,000
EBIT = ₹2,00,000

Step 3: Calculate DOL

DOL = Contribution / EBIT
DOL = ₹4,00,000 / ₹2,00,000
DOL = 2.0

Step 4: Calculate DFL

DFL = EBIT / (EBIT - Interest)
DFL = ₹2,00,000 / (₹2,00,000 - ₹80,000)
DFL = ₹2,00,000 / ₹1,20,000
DFL = 1.67

Step 5: Calculate DCL

DCL = DOL × DFL
DCL = 2.0 × 1.67
DCL = 3.34

Alternative Method:

DCL = Contribution / (EBIT - Interest)
DCL = ₹4,00,000 / ₹1,20,000
DCL = 3.33 (minor rounding difference)

Answer: Degree of Combined Leverage is 3.34.

Interpretation: A 10% change in sales will cause a 33.4% change in EPS.

5. Comparison of All Three Leverages

Leverage TypeMeasuresFormulaDepends OnRisk Type
Operating (DOL)EBIT sensitivity to SalesContribution / EBITFixed Operating CostsBusiness Risk
Financial (DFL)EPS sensitivity to EBITEBIT / (EBIT - I)Fixed Financial Costs (Interest)Financial Risk
Combined (DCL)EPS sensitivity to SalesDOL × DFLBoth Fixed CostsTotal Risk

6. EBIT-EPS Analysis

6.1 Purpose

To determine the indifference point between two financing alternatives (debt vs equity).

At the indifference point, EPS is the same under both plans.

6.2 EPS Formula

EPS Formula

EPS = [(EBIT - Interest)(1 - T) - Preference Dividend] / No. of Equity Shares

Where:

  • EBIT = Earnings Before Interest and Tax
  • T = Tax Rate
  • Interest and Pref Div = Fixed charges

6.3 Indifference Point Formula

Indifference Point

At indifference point, EPS from Plan 1 = EPS from Plan 2

[(EBIT - I₁)(1-T) - PD₁] / N₁ = [(EBIT - I₂)(1-T) - PD₂] / N₂

Solve for EBIT to find indifference point.

6.4 Numerical Problem (Exam Format)

Problem: ABC Ltd. needs ₹10,00,000 for expansion. Two plans:

  • Plan A: Issue 10,000 equity shares at ₹100 each
  • Plan B: Issue ₹10,00,000 in 10% debentures

Tax rate = 30%. Find: (i) EPS at EBIT = ₹2,00,000 under both plans (ii) Indifference point

Solution:

(i) EPS at EBIT = ₹2,00,000

Plan A (All Equity):

No. of shares = ₹10,00,000 / ₹100 = 10,000
Interest = ₹0

EPS = [(EBIT - I)(1-T)] / N
EPS = [(₹2,00,000 - 0)(1-0.30)] / 10,000
EPS = [₹2,00,000 × 0.70] / 10,000
EPS = ₹1,40,000 / 10,000
EPS = ₹14

Plan B (All Debt):

No. of shares = 0 (assume existing shares = 5,000 for comparison)
Interest = 10% of ₹10,00,000 = ₹1,00,000

EPS = [(₹2,00,000 - ₹1,00,000)(1-0.30)] / 5,000
EPS = [₹1,00,000 × 0.70] / 5,000
EPS = ₹70,000 / 5,000
EPS = ₹14

(ii) Indifference Point:

Set EPS of Plan A = EPS of Plan B

[(EBIT - 0)(0.70)] / 10,000 = [(EBIT - 1,00,000)(0.70)] / 5,000

Simplifying:
EBIT / 10,000 = (EBIT - 1,00,000) / 5,000

Cross multiply:
5,000 × EBIT = 10,000 × (EBIT - 1,00,000)
5,000 EBIT = 10,000 EBIT - 10,00,00,000
5,000 EBIT = 10,00,00,000
EBIT = ₹2,00,000

Answer:

  • EPS under both plans at EBIT ₹2,00,000 = ₹14
  • Indifference Point = ₹2,00,000 EBIT

Interpretation:

  • If expected EBIT > ₹2,00,000 → Choose Plan B (Debt) for higher EPS
  • If expected EBIT < ₹2,00,000 → Choose Plan A (Equity) for higher EPS

Exam Pattern Questions and Answers

Question 1: "Calculate DOL, DFL, and DCL." (6 Marks)

Given:

Sales: ₹8,00,000
Variable Cost: ₹4,80,000
Fixed Cost: ₹2,00,000
Interest: ₹40,000

Solution:

Contribution = ₹8L - ₹4.8L = ₹3.2L
EBIT = ₹3.2L - ₹2L = ₹1.2L

DOL = ₹3.2L / ₹1.2L = 2.67
DFL = ₹1.2L / (₹1.2L - ₹0.4L) = 1.2L / 0.8L = 1.5
DCL = 2.67 × 1.5 = 4.0

Answer: DOL = 2.67, DFL = 1.5, DCL = 4.0

Summary

Three Leverages:

  1. DOL = Contribution / EBIT (Business Risk)
  2. DFL = EBIT / (EBIT - I) (Financial Risk)
  3. DCL = DOL × DFL (Total Risk)

Higher Leverage = Higher Risk BUT Higher Reward potential

EBIT-EPS Analysis helps choose optimal financing mix

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Quiz Time! 🎯

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