Degree of operating leverage pdf

The degree of financial leverage DFL can be computed by measuring percentage change in taxable profits caused by a given percentage change in EBIT. This can be expressed as follows:. It should be noted that financial leverage exists only when the quotient as per the above equation is more than one. Illustration 8. It helps in finding out the resulting percentage change in taxable income on account of percentage change in sales.

This can be computed as follows:. Illustration 9: i If operating leverage of a firm is 2. Find out the combined leverage. Find out the Combined Leverage. Your email address will not be published. Contents 1 Leverage Bcom Notes 1. It basically relates to determining capital structure of the firm. Both are important and have their own merits and demerits. The use of debt and equity depends upon numerous factors. The debt financing results in fixed financial charge on the income of the firm but does not interfere in the decision making of the firm as debt holders have no voting rights whereas equity does not involve any fixed financial charge but results in division of the ownership right.

Either of two financing source cannot be good for a company in all circumstances. Therefore, finance manager needs to ascertain and review from time to time the best suited proportion of debt and capital in its capital structure.

The best mix of debt and equity which leads to maximisation of shareholders wealth through maximisation of market price of equity share is known as optimum capital structure. There are two techniques to calculate the impact of debt and equity in overall capital structure of the firm viz.

Value Addition 1: Video Benefits of Investing in Equity, Debt and Liquid Instruments Click on the link below to gain an insight into the benefits of investing in equity, debt and liquid instruments. Equity Click on the link below to know more about the advantages and disadvantages of debt and equity.

Concept of Leverage: In general terms, leverage means relationship between two interrelated variables. While studying the concept of leverage, it is to be remembered that the two variables are related to each other i. The dependent variable is shown as a numerator whereas independent variable is shown as a denominator. It can also be explained as a responsiveness of a dependent variable due to a change in the independent variable.

It means there is Rs 5 increase in sales revenue because of one rupees increase in advertisement expenses. Types of Leverage Analysis: Leverage analysis in financial management can be divided into three sections: Figure 3: Types of Leverage Analysis 4.

Operating Leverage: Operating leverage measures the impact of sales revenue on the operating profits of the firm EBIT. Operating leverage is an indicator of the business risk of the firm. Business risk means variability in the EBIT of the firm because of employment of fixed operating cost. Business risk of the firm depends upon internal as well as external factors. These external factors may be peculiar to a particular company or may be common to all the companies.

Normally, business risk is unavoidable. Operating leverage will occur only when firm is incurring fixed operating expenses. Therefore, existence of fixed operating cost in the overall cost structure of the firm will have magnifying effect of percentage increase in sales over EBIT. Higher operating cost results in higher business risk therefore higher operating leverage. Thus, operating leverage is an index of business risk of the firm.

If there is no fixed operating cost then operating leverage will not exist. Thus, no business risk to the firm. Illustration 1: A company sells units 10 Rs per unit. The variable cost of production is Rs. Calculate Operating Levearge.

Then, new equation will be Sales units Rs 10 per unit. Thus, in the absence of fixed operating cost in the cost structure of the firm any increase or decrease in the sales will have no magnifying effect over EBIT. Therefore, one can say that operating leverage does not exist in present case. Therefore, one can say that because of existence of fixed operating cost, operating leverage exists. Higher operating cost results in higher operating leverage.

Though higher operating leverage may not be good but every firm must have some element of fixed operating cost in order to have magnifying effect of sales on EBIT. The behaviour of operating leverage will depend upon the position of sales vis-a-vis break even sales of the firm.

If the present level of sales is more than breakeven level of sales the DOL will decrease with every increase in sales level and vice versa.

This is because, increase in fixed cost is relatively smaller then increase in sales level. It measures the magnifying effect of change in EBIT because of change in sales, which results because of fixed operating cost. If there is no fixed operating cost, then there will be no operating leverage or degree of operating leverage will be one.

A positive operating leverage means firm is operating at a higher level than break- even point. Importance of Operating Leverage: The study of operating leverage helps the finance manager in a. To show impact of changes in sales on the level of operating profits EBIT of the firm b.

In case of higher DOL, a firm can earn huge profits by increasing sales volume. Firm will incur losses if there is substantial decrease in sales volume. Therefore firm should avoid operating under high DOL.

Higher DOL represents higher operating risk thereby increasing overall risk of the firm. The study of DOL helps manager to take calculated risk. Financial risk occurs because of inability of the firm to pay its fixed financial costs. If firm is not earning enough to pay interest or their fixed payments the financial risk as well as overall risk of the firm will increase, So, finance manager should consider the level of debt in the capital structure while taking financial decisions.

If the firm is financed through equity capital, then there will be no financial risk. Enter the email address you signed up with and we'll email you a reset link. Need an account? Click here to sign up. Download Free PDF. Miguel Sanchez. A short summary of this paper.

Download Download PDF. Article by Madhuri Thakur. The concept of DOL revolves around the proportion of fixed costs and variable costs in the overall cost structure of a company.

A company with a higher proportion of fixed costs has a higher DOL as compared to a company with a higher proportion of variable costs. If in case the DOL is high, then the earnings before interest and taxes Earnings Before Interest And Taxes Earnings before interest and tax EBIT refers to the company's operating profit that is acquired after deducting all the expenses except the interest and tax expenses from the revenue. It denotes the organization's profit from business operations while excluding all taxes and costs of capital.

The formula can be derived by using the following three steps: Firstly, determine the operating income vs. EBIT during the current year and the previous year. Leave a Reply Cancel reply Your email address will not be published.