Leverage means the fixed commitment of the organization. The fixed commitment of the organization can be classified into two different categories viz fixed cost of operations
and fixed cost of servicing. The fixed cost of operations are pertaining to the investment decisions and the fixed cost of servicing with reference to the financing decision.
Fixed cost of operations – Investment decisions.
Fixed cost of servicing – Financing decisions.
If Revenues are more than the Variable Cost and Fixed Cost, that is called favorable or otherwise unfavorable.
Operating Leverage is connected with the acquisition of assets where as the financial Leverage is connected with the Financing of activities.
Operating leverage: It is a relationship in between the Sales and Earnings before
interest and taxes.
Financial leverage: It is a relationship in between the Earnings before interest and
taxes and Earnings per share.
Operating and Financial: In the Operating and Financial leverages, the EBIT is found
as a common phenomenon. During the first part of the chapter, let us discuss about the
operating leverage. It emerges only due to Fixed operating expenses. By and large, the
expenses are classified into two categories viz Fixed and Variable in categories for the
analysis of leverage.
Operating Leverage is defined as the ability to use fixed operating costs to magnify
the effects of changes in sales on its earnings before interest and taxes.
Described as % change in profits accompanying the % change in volume.
"The firms' ability to use fixed operating costs to magnify the effects of changes in
the sales on its earnings before interest and taxes".
A firms sells products for Rs 100 per unit has variable operating costs of Rs. 50 per
unit and fixed operating cost of Rs. 50,000 per year. Show the various levels of
EBIT that would result from sale of i) 1000 units ii) 2000 units iii) 3000 units.
From the above illustration
The next leverage is Financial Leverage which arises due to servicing of financial
It results from the presence of fixed financial charges in the firms. The fixed
financial charges are nothing but the preference dividend and interest on the fixed
charge financial resources.
Financial leverage, how the fixed charge financial resources influence the EBIT
of the firm and finally provides earnings to the shareholders. It reveals the ability
of the firm to make use of "fixed financial charges to magnify the effects of changes
in EBIT on the earnings per share". The other name of the financial leverage is Trading on Equity, which illustrates the relationship in between the application of the fixed charge of funds in the capital structure and Earning per share. It is the leverage analysis highlights the relationship in between the financing decision and investment decision.
The fixed financial charge should pave way for the firm to not only to earn the greater
EBIT but also to magnify the EPS of the shareholders.
The financial manager of the hypothetical ltd expects that its earnings before interest and taxes (EBIT) in the current year would amount to Rs.10,000. The firm has 5 percent bonds aggregating Rs.40,000 while the 10 percent preference shares amount to Rs. 20,000 what should be the earnings per share (EPS)? Assuming the EBIT being i) Rs.6,000 Rs.14,000. How EPS is affected ? The firm tax bracket 35%. Ordinary number of shares 1,000
It is an analysis to study the impact /effect of the leverage. This could be studied through
comparison of various financing plans of EBIT.
(i) Exclusive use of debt
(ii) Exclusive use of Equity shares
(iii) Exclusive use of Preference shares
(iv) Combination of (i), (ii) & (iii)
(v) Combination of (i) & (ii)
(vi) Combination of (ii) & (iii)
(vii) Combination of (i) & (iii)
Among the various plans, we have to identify the best plan which has highest EPS over
the others.
The firm which has highest EPS normally has least volume of fixed financial charge
over the other firms.
What is meant by financial break even point ?
It is the level of EBIT to meet the fixed financial charge of the firm viz Interest on long
term borrowings/Debentures and Preference dividend on Preference shares.
The following formula is used to compute the financial break even point for the firm to
earn at least to cover the fixed financial charges of the firm:

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