Operating and Financial leverages

Q.1 What do you mean by leverage?
Ans. Leverage means the employment of assets or funds for which the firm pays a fixed cost or fixed return. The fixed cost or fixed return. The fixed cost or return may be thought of as the fulcrum of a lever. In mechanics the leverage concept is used for a technique by which more weight is raised with less power. In financial management the leverage is there an account of fixed cost. If any firm is using some part of fixed cost capital than the firm has leverage which can be used for raising profitability and financial strength of firm.



Q.2 What is operating leverage? Give the formula of calculating operating leverage and degree of operating leverage?
Ans. Operating leverage is defined as the ability to use fixed operating costs to magnify the effect of changes in sales on its operating profits. If the fixed operating costs are more as compared to variable operating costs, the operating leverage will be high and vice-versa. Thus, the term ‘Operating leverage’ refers to the sensivity of operating profit to changes in sales.
For example, if the sales increase by say 20% and the operating profit increases by 100% it is a case of high operating leverage.
Computation of Operating leverage:-
Operating Leverage = Contribution/Operating Profit     Or          Sales – Variable cost/Contribution – Fixed Cost
Degree of Operating Leverage- (DOL)
The degree of operating leverage may be defined as the percentage change in operating profits resulting from a percentage change in sales
-On two levels of sales for comparison:-
Degree of operating leverage (DOL)= percentage change in profits/Percentage change in sales
-On one level of sales:-DOL = Contribution/EBIT



Q.3 What is favorable operating leverage and what is the utility of operating leverage?
Ans. When the profits increase with the increase in sales it is called favorable
operating leverage.
Utility of operating leverage:
Operating leverage helps in capital structure decisions and play a vital role in formulation of an optimum capital structure. It is most helpful in long term profit planning as it is useful in taking decisions regarding capital expenditure. It is true to say that operating leverage is basically used in taking capital budgeting decisions.




Q.4 What is meant by ‘financial leverage’? How it is computed?
Ans. Financial leverage arises from the presence of fixed financial costs in the income stream of the firm or due to presence of fixed return securities in the capital structure of the company. Fixed cost securities are debentures and preference share.
Thus financial leverage is defined as, ‘the firm ability to use fixed financial cost to magnify the effect of changes in earnings before interest and tax (EBIT) on firm’s earnings per share. (EPS)
Financial leverage may be favorable or unfavorable. If the earnings made by the use of fixed interest bearing securities is more than their fixed costs. The firm is considered to have ‘favorable financial leverage’ or trading on equity. If the firm earns less than the cost of borrowed funds, the firm is said to have an ‘unfavorable financial leverage’.
Computation of Financial leverage:-
Financial leverage = Earnings before interest and tax/Earnings before tax but after interest


or
FL = EBIT/EBT
Degree of Financial leverage: (DFL)
(a) On one level of profit:
DFL = EBIT  or Operating Profit/EBT
(b) On two level of profit for comparison :
DFL = %Change in EPS/% Change is EBIT



Q.6 Give difference between operating and financial leverage.
Ans. Difference between operating and Financial leverage------

1.Operating Leverage-Establishes relationship between sales and Operating Profits
Financial Leverage- Relationship between Operating profits and return on owners equity.
2.Operating Leverage- Concerned with investment decisions
Financial Leverage-Concerned with method of finance.
3.Operating Leverage- Refers to fixed costs in the operations
Financial Leverage- Refers to the use of borrowed funds.
4.Operating Leverage- Relates to the assets side of Balance sheet.
Financial Leverage-Relates to the liability side of Balance Sheet.
5.Operating Leverage-Involves operating risk of being unable to cover fixed operating cost.
Financial Leverage-Involves financial risk being unable to cover fixed financial cost.
6.Operating Leverage-First stage leverage.
Financial Leverage-Second stage leverage as financial leverage starts where operating leverage ends