Table of Contents
|Leverage Analysis In Financial Management|
What are the types of leverage?
Leverage analysis and financial management. What leverage means. Leverage refers to the amount of depth; a firm uses to finance assets. Whenever a business is going to be started there is a requirement of certain assets for it.
There is a requirement for a building to be built up where the businesses would be run so suddenly fixed cost is always involved in a business, and these fixed costs,
Their existence gives rise to leverage is a kind of depth or risk involved in the business.
We will see how leverage affects the business how it magnifies his various profits and losses which occur in the business. It is an investment strategy to use borrowed money.
Whenever the business is going to be started there is required a huge capital to be invested in it for the basic starting for the basic beginning of that business.
All those fixed assets which are acquired by this borrowed money gives rise to the leverage in very simple terms means the depth, the depth, which is because of the existence of the fixed cost.
All those assets could be pieces of machinery equipment, tools and the tools and the basic infrastructure of the building, whatever is required the officers.
How do you analyze financial leverage?
All those assets, which are the fixed assets the assets that are fixed in nature, which does not vary with the number of units produced which do not vary with the production,
Whether you are making 100 units or product whether you are making 1000 units or product, the fixed costs would remain the same. And those fixed costs.
If that exists in business, and the capital is involved in it because to acquire those fixed assets, then the business is leveraged, and higher the fixed cost higher is the leverage on the business.
But the larger presence of fixed costs profit margins can get squeezed. When the business scenario is not favourable and this is fun.
This adds risk to the stocks of such companies. Okay, so we will see how fixed cost affects the business it magnifies it magnifies both effects,
Either on the profit or the loss because of the presence of fixed costs, and why it is effective because a fixed cost is an amount
Which is a larger amount which you are investing in your business to start your business to run your business for a longer period
The variable cost would depend on the units of production being met. But the fixed cost would be the basic building block of your business.
What is the financial leverage ratio formula?
And conversely with the same larger presence of fixed costs company would experience magnified profits with an increase in sales, as the cost level remaining constant.
We would look after and try to understand how the existence of fixed costs affect profit margins, or how it magnifies both the effects either on the profit or on the loss in the business.
Try to understand the scenario I have taken two cases case one case two and case three their venue for case one is 15 lakhs and then it increased to 21 lakhs.
In case number two and then it decreased to 12 lakhs. What happened? If you look at the percentage change in revenue.
From the case, in case two we have seen that the revenue has changed from 15 lakhs. It has increased to 21 lakhs. So there are 40% changes in revenue, whereas when we talk about case number three,
The revenue decreased to 12 lakhs. So there is a negative 20% change in revenue. Now we will try to understand how this change in revenue has impacted the profit,
And why it has impacted because of the presence of the fixed cost. These are the fixed costs, 10 lakhs rupees which are remaining constant in all the cases.
And by deducting fixed costs from the venue we are arriving at a profit, assuming that there is no variable cost in the business.
This sees the person has changed in profit because of the change in revenue. From 15 lakhs. We deducted the fixed cost of 10 lakhs we got a profit of five lakhs.
And likewise for case two and case three, so see the person has changed in profit in case two, it has been 120%from five lakhs. It has raised to 11 lakhs and does we got 120% change in profit violin case three,
We have got a negative 60%, which is a lost 60% loss, and just you can see the impact because of the presence of fixed cost, we can see that for 40% change in revenue.
There is a 120% change in profit, almost three times, and 420% loss because of the presence of the fixed costs there is 60%. Sorry for the 20% loss in phase two, which is going negative so there is a 60% loss.
And you can see this is also almost three times and why this is happening because fixed cause there is the presence of only fixed cost, and this is magnifying the impact
If the condition is favourable. Like if there is a positive for 2% our business is doing good because of some reason the sales,
Increasing we are doing well with our marketing strategies. So the presence of fixed costs would magnify the fact of the profit and we would get a better profit,
But in any condition, if the economy certainly scenario is not favourable and our business is not doing good.it would result in a magnified loss as well. There we can see we are getting a negative 60%.
Now the types of leverage are, we can classify leverage into operating leverage, which arises because of the presence of forms fixed operating costs,
Operating costs could be the salaries the ranks with because these costs are fixed in nature, these are to be paid on the monthly basis on a fixed amount.
What is financial leverage and why is it important?
Unless any changes are being made depreciation which is charged on any of the fixed assets on an annual basis,
Or a monthly basis, then there are utility expenses like electricity, water charges, etc. All these expenses which are fixed in nature give rise to the operating leverage,
Because these expenses need to be paid. They are compulsory to be paid the independent of the variable cost independent of the products being made in the business.
These are compulsory which is obligatory in the business to run the business.
Thus, it gives rise to a certain amount of responsibility on the business it needs to be paid. That is what the basic concept of leverage is when we about the financial leverage it arises with the presence of forms fixed financing costs,
Such as interest expenses on the depth and preference shares. if the farm has borrowed money, either through a loan or preference shares, it has to pay certain interest on that on a fixed interval of time.
This interest expense also gives rise to leverage because we are paying it on a fixed interval of time, and it is obligatory for business.
It is fixed in nature which is occurring which is, which is reoccurring, and this is creating a debt on the business.
That’s what leverage means, and then there is combined leverage which is a product of operating and financial leverage.
It would do give an overall leverage picture, whether in the terms of operating or financial it will provide a total view of the, of the company.
Let’s see some of the formulas so we would be using these formulas to calculate the degree of operating leverage is the degree of financial leverage is and the degree of combined averages.
Just try to understand. It’s like sales minus variable cost would give you the contribution. And when you did a fixed cost from this contribution,
We would be arriving at earnings before interest and taxes, earnings before interest in taxes also referred to as profit before interest, interest,
And tax, then we would be deducting the interest out of it and, and we would be arriving at earnings before tax we can call it profit before tax as well. Earnings before tax and deducting tax out of it
We will be arriving at earnings after tax or profit after tax that is also referred to as pat, and then we can calculate the only portion,
Which is the earning after tax divided by the number of shares issued so what we are doing. We are just deducting.
Both the cost is the variable cost or fixed costs from overseas, which is a source of our revenue to arise at profit.
And then we are deducting our fixed financial leverage status interest and then we are arriving at after that we are giving away all the taxes
And we are arriving at the net profit of ours, out of that net profit what we are giving to our shareholders is running kosher.
Let’s see the formulas for operating leverage his financial leverage and combined leverage. The degree of operating leverage is a contribution by debit.
This is how we calculate operating leverage would show but do give us a view of how our business is going how our businesses to leverage.
Is it okay or is it too much you in the depth degree of financial leverage would be equal to Ebit divided
And the degree of financial leverage could also be calculated and the person has terms like percentage change in aps by percentage change in
Ebit degree of combined leverage would be the product of operating leverage and financial leverage, or you can use the formula of the percentage change in eps by the percentage change in sales.
Now try to understand, because of the change in sales how much you’re earning how much your profit is being impacted.
That is what the degree of operating leverage is said to signify. And because of the percentage change in your earning,
What is the percentage change in the earnings per share that is the earnings for the shareholders what is that, because of the change in your profit?
That would be shown by the degree of financial leverage and at last, the degree of combined leverage would show how a percentage change in sales is impacting the earnings per share,
Earnings per share, which is your final, final point where the profits whatever you are having the net profit. That is what we refer to,
Which can be paid to the shareholders or could be invested in the business before the improvements.