What is Leverage in Finance | ApnaCourse

 Manu

Conversation Between

Vinu

 Manu and Vinu about
Leverage

So you are my Guru now 

Straight to the topic!

Leverage is one of the beautiful and important concept in Financial Management.

What is the purpose of Lever?

Exactly and this would be the process!

That sounds very strange and how do you say that?

More fixed cost is a cost.

Higher cost will reduce the profits.

But still, more fixed cost means, you can make more profits!

Assume a sales for 2013-14

This is because, your cost is Rs.90 Crs.

Now tell me, what will be your profit, when your sales doubles?

When Sales is Rs.100 Crs, profit is Rs.10 Crs.

So obviously, when sales touches Rs.200 Crs, profit should be Rs.20 Crs.

When your sales increased, variable cost also increased in the same proportion.

i.e., your existing level of variable cost is 80% (80/100) and it continued to be at 80% (160/200) when your sales increased to Rs.200 Crs.

But your fixed cost remained fixed at Rs.10 Crs.

I said your profit will go up when you have more fixed costs right?

Increase your Fixed Cost and see what the effect on your profit is, without changing the total cost.

What are your existing costs?

Increase your fixed cost without changing the total cost.

I’ll assume

Variable Cost as Rs.50 Crs

Fixed Cost as Rs.40 Crs

So my total cost will continue at Rs.90 Crs

100 Crs to 200 Crs.

When my fixed cost was 10 Crs, I could achieve only Rs.30 Crs profit on sales of Rs.200 Crs.

But it jumped to 60 Crs, when my fixed cost had become 40 Crs.

When you had low fixed cost, the increase in profits for increase in sales is low.

But, when you added higher fixed cost, proportionate increase in profit when compared with increase in sales is very high.

Do you mean to say, that companies should have more fixed cost to make more profit?

When you have more contribution and more fixed cost, how can your profit can be more?

That’s why your profit will have disproportionate increase when compared with increase in sales.

Because, when you take more fixed cost, it means you have less variable cost.

With increase in sales, VC will also move along with sales and so you will have more contribution.

More contribution for every additional sales but fixed cost will be fixed.

So we can have more profits!

But, it will work absolutely in opposite direction when your sales comes down. Because, when sales comes down, you contribution will also come down but not your fixed cost.

Even a marginal fall in sales can affect us, I think!

Assume 30% fall in your sales, when your fixed cost is Rs.40 Crs and sales is Rs.100 Crs.

For 30% decrease in Sales, you are going to report Loss of Rs.5 Crs

30% decrease in sales is causing 150% fall in your profits. i.e., resulting in loss.

It is also because of Fixed Cost!

For that we have to split fixed costs further!

a)  Operating Fixed Cost

b)  Non-Operating Fixed Cost

This one?

You have assumed Operating Fixed Cost as Rs.20 Crs and Non-Operating Fixed Costs as Rs.20 Crs

In this case, you have Contribution of Rs.50 Crs whereas your EBIT is Rs.30 Crs.

Why did this happened?

This tells us about Operating Leverage.

Your Operating Fixed Cost determines Operating Leverage.

Contribution / EBIT = 50/30 = 1.67 Times.

50/30 = 1.67 Times.

EBIT has grown by 1.67 Times.

Exactly as provided by Operating Leverage.

At higher level, CFOs will be interested in knowing what will be the impact on EBIT if their sales

increases / decreases and they will be making use of Operating Leverage to know that!

increases, your EBIT will grow by Operating Leverage Multiples.

EBT is decided by Non-Operating Fixed Cost like Interest Charges.

Is that right?

Your EBIT will get reduced by Non-Operating Fixed Cost and will give you EBT.

The relationship between EBIT and EBT is called as Financial Leverage.

EBIT/EBT = 30/10 = 3 Times

More importantly, it says, if your EBIT increases by certain proportion, then your EBT will increase by 3 Times of that proportion.

sales to Rs.200 Crs.

It had grown from 30 to 80.

Growth by 50.

If you express it in times – it is 50/30 = 1.67 Times.

Financial Leverage actually says, EBT will grow by 3 Times of Growth in EBIT Times.

i.e., 3 x 1.67 Times = 5 Times.

It had grown to Rs.60 Crs.

i.e., 10 + 50 = 60

When your sales changes, automatically, you will know what will be the effect on EBIT through Operating Leverage.

Once you know the effect on EBIT, you can find the effect on EBT through Financial Leverage.

We can find the direct effect of change in sales on profit through Combined Leverage.

For your existing sales, contribution is 50 and EBT is 10.

It says, when sales increases, EBT will increase by Combined Leverage Times.

Existing Sales – 100 Crs

Proposed Sales – 200 Crs

Sales increased 1 Time.

EBT should increase by 5 Times of 1 Time.

ie., EBT should increase by 5 Times. (5 x 1)

Existing EBT is Rs.10 Crs

Increase by 5 Times = 10 x 5 = 50 Crs

Yes!!!!

Proposed EBT in our table and this computation matches. It is Rs.60 Crs (10+50)

CFOs use this tool to know what will be direct impact in EBT when your sales changes.

In our example, existing sales and EBIT was Rs.100 Crs and Rs.10 Crs.

CFOs will not go further detailed computation, if they have Combined Leverage on hand.

If they know Combined Leverage is 5 Times, then automatically they can come to a conclusion

that, if there sales increases to 200 Crs, then their EBT will become Rs.60 Crs.

Yes! It is simple. But it saves lots of times and provide instant tools for people at the top

management level to make quick decisions.

If operating leverage is high, it means they have high operating fixed cost. So in good times, they

tend to make more EBIT. In bad times, they should take efforts to reduce the operating fixed

costs as variable cost so they don’t suffer fall in EBIT.

But they have to be careful, when their sales reduces. In such period, higher financial leverage is

a strong warning indicator for the company to reduce non-operating fixed costs.

If you have higher leverages, you tend to make more profits in good times and suffer badly in bad times.

So your costing structure should be flexible enough to convert the costs into fixed and variable depending upon changing circumstances.

Now I could understand the importance of Leverage.

Thank you! But the session got a bit lengthier!

Thank you very much.