Leverage Analysis

Dear Friends,
Leverage analysis is the part of management accounting. This is the duty of finance manager to use the technique for making ideal structure of capital. Leverage analysis is the best technique of finance manager. With this technique he can make wonderful structure of capital. For doing leverage analysis he has to calculate three leverage
1st leverage – Operating Leverage
Operational leverage is calculate by following formula

Operational leverage =

% change in Earning before interest and tax
% Change in Sales
Analysis of operating leverage of a firm is very useful to the financial manager. It tells the impact of changes in sales on operating income. A firm having higher Degree of operating leverage can experience a magnified effect on E.B.I.T. for even a small change in sales level. Higher D.O.L. can dramatically increase the operating profit. But if there is decline in sales level, E.B.I.T. may be wiped out and a loss may be operated.
2nd leverage - Financial Leverage
Financial leverage can be calculate with following formula

% change in Earning per share
= ____________________________________

% change in Earning before interest and tax

Financial leverage helps the finance manager in designing the appropriate capital structure. One of the objectives of planning an appropriate capital structure is to maximize the return on equity shareholders’ funds or maximize the earning per share.
Financial leverage is doubled edged sword. On the one hand it increase earning per share and on the other hand it increase financial risk. A high financial leverage means high fixed financial costs and high financial risk i.e. as the debt component in capital structure increases , the financial leverage increases and at the same time the financial risk also increase .
So the finance manager therefore is required to trade off i.e. has to bring a balance between risk and return for determining the appropriate amount of debt in the capital structure of a firm. Thus the analysis of financial leverage is most important tool in the hands of finance managers who are engaged in financing the capital structure of business firms, keeping in view the objectives of their firm.
3rd leverage – Combined leverage
The combined leverage measures the effect of a % change in sales on % change in Earning per share.
Combined leverage = operating leverage X financial leverage
Combined leverage=

% change in E.B.I.T. % change in E.P.S.
________________ X ___________________

% change in sales % change in E.B.I.T.

The ratio of contribution to earning before tax , given by combined leverage shows the combined effect of financial and operating leverage . A high operating and high financial leverage combination is very risky. If the company is producing and selling at a high level , it will make extremely high profit for its shareholders. But even a small fall in the level of operations would result in a tremendous fall in earning per share. A company must , therefore maintain a proper balance between these two leverage.






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Accounting Education: Leverage Analysis
Leverage Analysis
Accounting Education
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