The degree of Operating Leverage, Financial Leverage and Combined Leverage
Introduction
The financial management of an organisation has to make three decisions, such as financing decisions, investment decisions and dividend decisions. The investment decision relies on the financing decision as the fund for making the investment can be financed from different sources. Debt financing and equity financing are the most common sources of financing for modern firms. Before starting the discussion, we need to note that debt funds and equity funds are raised against specific costs and a firm has to pay interest against debt capital and dividend against the equity capital. In addition to that, it is also required to be noted that the interest cost or finance cost is a periodic cost and the lendee has to pay the interest before complete repayment of such loan. Thus, this cost is considered as a fixed cost or fixed finance cost. Apart from fixed finance cost, a company incurs fixed costs in order to meet some operational need. Costs such as rent and depreciation are examples of such operational costs, which are termed as operating fixed cost. Thus, it can be said that there are two types of fixed costs such as operating fixed cost and finance fixed cost.
In leverage-analysis, the risk of a company arises for the stated fixed cist is examined. In finance, the term "leverage' is used for making the risk-return analysis. This is also used for ascertaining the optimum capital structure. The current discussion shall focus on different types of leverages and their uses in business decision making.
Definition, meaning and concept of leverage
In general sense, "leverage" means utilising a resource or power for the best possible outcome. In finance, leverage is the efficiency of a firm to use fixed costs in making the profit. Low efficiency of earning a profit by using the fixed costs are considered as a risk. In other words, the leverage can also be explained as a way of determining the interrelation between two financial variables. In this regard, it is to be stated that the financial variables include Revenue, Fixed cost, Variable cost, Contribution, Earnings Before Interest and Tax (EBIT), Earnings Before Tax (EBIT), Earnings After Tax (EAT) and Earnings Per Share (EPS). The stated variables can be calculated with the help of the following hypothetical income statement.
Leverage Measures
Leverages are of three types:
a) Operating Leverage
b) Financial Leverage, and
c) Combined Leverage or Total Leverage.
Measurement of these leverages depends to a large extent on the various financial variables as discussed in the income statement and the relationship that exists between them.
Operating Leverage
The operating leverage is based on the cost structure of a firm and it refers to the use if fixed operating costs in the production process of the firm. A manufacturing firm with high operating leverage will have comparatively high fixed operating cost in comparison with a firm with low operating leverage. In this regard, it is to be stated that the operating fixed cost plays the most crucial role in examining the operating leverage of a firm. The operating leverage rises with the rise in the operating fixed cost. If total cost of any firm involves a higher proportion of fixed cost as compared to the variable costs, such a firm would have higher operating leverage. In this context, it is also to be noted that a small change in revenue or sales will have a great impact on Earnings Before Interest and Tax (EBIT) or operating profit of a firm under such circumstances.
The operating leverage of a firm can be computed by using the following formulae:
Degree of Operating Leverage (DOL)
= Percentage (%) change in Operating profit (EBIT)
Percentage (%) change in Sales
Or Contribution
Operating profit (EBIT)
Financial Leverage
The financial leverage is based on the capital structure or the proportion of debt capital and equity capital in the capital structure of a firm. The pressure of debt capital on the profitability of a firm can be determined by the financial leverage. A capital structure with high debt capital will have higher financial leverage as compared to a firm with a capital structure with smaller debt financing. In this regard, it is required to be noted that a rise in debt capital results in an enhancement of interest expense and therefore if a company is having high debt capital would have to incur a significant amount of interest expense or fixed financial charges. As the earnings available to the equity shareholders are calculated after deducting the interest expense, these fixed financial charges have a deep impact on the earnings per share (EPS). Thus, the financial leverage can be understood as the ability of a firm to use fixed financial charges to magnify the effects of change in operating profit on the firm's earnings per share (EPS).
The measurement of the degree of financial leverage can be made by using the following formulae:
Degree of Financial Leverage (DFL)
= Percentage (%) change in Earnings Per Share (EPS)
Percentage (%) change in Operating profit (EBIT)
Or Operating profit (EBIT)
Earnings Before Tax (EBT)
Combined Leverage
From the above discussion, it is clear that a firm has to incur two types of fixed costs, the first one is operating fixed cost the final one is financial fixed costs. Through DOL, the burden of operating fixed cost can be understood and the effect of fixed financial charges can be known by using the DFL. The combined leverage helps in magnifying the effect of both fixed costs in the earning capacity of a firm. In other words, analysis of operating fixed cost and the financial fixed cost can be ascertained through the combined leverage. Thus, it can be stated that the overall impact of the change in sales on the earnings per share (EPS) can be analysed by using the combined leverage. A high degre of combined leverage signifies a high risk of a firm.
The degree of combined leverage or total leverage can be calculated by using the formulae below:
Degree of Combined Leverage (DCL) =
DOL X DFL
or,
Percentage change in Earnings Per Share
Percentage Change in Sales
or, Contribution
EBT
Conclusion
In the above discussion, it is clear that fixed financial charges or interest on a loan and operating fixed cost affect the profitability of a firm. The risk associated with the financial fixed cost can be quantified through the Degree of Financial Leverage (DOL) and the risk for incurring operating fixed cost can be evaluated through Degree of Operating Leverage (DOL). Apart from these two, the overall risk of a firm can be ascertained by using the Degree of Combined Leverage. High financial leverage with low operating leverage or high operating leverage with low financial leverage is to be considered as the optimum cost structure and due to this reason, a firm must focus on all the three leverages in order to maximise its profit.
Reference
Bartram, S.M., Brown, G.W. and Waller, W., 2015. How important is financial risk?. Journal of Financial and Quantitative Analysis, 50(4), pp.801-824.
Goel, U., Chadha, S. and Sharma, A.K., 2015. Operating liquidity and financial leverage: Evidences from Indian machinery industry. Procedia-Social and Behavioral Sciences, 189, pp.344-350.
Brigham, E.F. and Ehrhardt, M.C., 2002. Financial management: theory and practice. 10 th. Melbourne: Thomson Learning.
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