What is Leverage in Finance | ApnaCourse

by | Nov 10, 2016 | Financial Management

 Manu

Conversation Between

Vinu

 1

 Manu and Vinu about
Leverage

 2
Manu Hi Vinu!
Vinu Hi Guruji!!
Manu Guruji??
Vinu Yes! Today you are going to teach me about Leverage concepts in Financial Management.

So you are my Guru now 

Manu With pleasure! I love teaching and it’s my passion.

Straight to the topic!

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

Vinu I know, that Lever is a technical tool. But how it is used in Financial Management?
Manu That’s a good observation.

What is the purpose of Lever?

Vinu As for as I understand, Lever can be used for lifting heavy weight by giving less pressure.
Manu Yes!

Exactly and this would be the process!

 1
Vinu Yes!
Manu In the same way, you can also achieve better profits in your business by following principles of lever. i.e., leverage
Vinu How?
Manu If you have more fixed costs in your business, you can make more profits!
Vinu  2 What??????????

That sounds very strange and how do you say that?

More fixed cost is a cost.

Higher cost will reduce the profits.

Manu I agree!

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

Vinu I just can’t digest that! Please explain me with some numbers!
Manu Ok!

Assume a sales for 2013-14

Vinu Ok! Let it be Rs.100 Crs
Manu Fine, assume cost for the sales.
Vinu Let it be Rs.90 Crs
Manu Fine! It means, you are going to make a profit of Rs.10 Crs
Vinu Yes!

Sales 100 Crs
Cost 90 Crs
Profit 10 Crs
Manu Now it’s time to split your costs!
Vinu Likes?
Manu Based on nature!
Vinu As fixed and variable?
Manu Yes!
Vinu Ok! Out of Rs.90 Crs, let Rs.80 Crs be variable cost.
Manu So your fixed cost is Rs.10 Crs only!
Vinu Yes.
Manu Then please split your cost and work out your profits
Vinu
Sales 100 Crs
Variable Cost 80 Crs
Fixed Cost 10 Crs
Profit 10 Crs
Manu So when your sales is Rs.100 Crs, your profit is Rs.10 Crs.

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

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

Vinu Hmmm?

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.

Manu No! It need not be!
Vinu Why?
Manu Compute in a table format and tell me!
Vinu
Particular Existing Proposed
Sales 100 Crs 200 Crs
Variable Cost 80 Crs 160 Crs
Fixed Cost 10 Crs 20 Crs
Profit 10 Crs 20 Crs
Manu No! You are wrong!
Vinu Why?
Manu Your fixed cost got to be fixed. But you considered that also as a variable cost!
Vinu Ya! Let me correct it!

Particulars Existing Proposed
Sales 100 Crs 200 Crs
Variables Cost 80 Crs 160 Crs
FIXED COST 10 Crs 10 Crs
Profit 10 Crs 30 Crs
Manu Now look at your profit!
Vinu Hey!!!! It is Rs.30 Crs. How did this happened?
Manu It happened because of your fixed cost.

 

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.

Vinu Yes! Very true.
Manu That’s why it is said, Variable cost will become fixed and Fixed cost will become variable.
Vinu  3
Manu Variable cost per unit will be constant but Fixed cost per unit will change depending upon your sales.
Vinu Yes! Yes!
Manu Now come back!

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

Vinu Yes!
Manu Change your cost assumptions!

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

What are your existing costs?

Vinu
Variables Cost 80 Crs
Fixed Cost 10 Crs
Manu Now make alteration to this composition.

Increase your fixed cost without changing the total cost.

Vinu Ok!

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

Manu Work out your existing and proposed profits
Vinu
Particulars Existing Proposed
Sales 100 Crs 200 Crs
Variables Cost 50 Crs 100 Crs
FIXED COST 40 Crs 40 Crs
Profit 10 Crs 60 Crs
Manu Look at your profit!
Vinu  4 It jumped from 10 Crs. to 60 Crs. When sales increased from

100 Crs to 200 Crs.

Manu Also note your profit jumped from 30 Crs to 60 Crs at your 200 Crs sales level.
Vinu Yes!

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.

Manu True! Can you tabulate this?
Vinu
Particulars Low Fixed Cost High Fixed Cost
Sales 100 200 100 200
Variables cost 80 160 50 100
Fixed Cost 10 10 40 40
Profits 10 30 10 60
Manu The above table shows,

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.

Vinu True!

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

Manu  5
Vinu Then?
Manu Your total cost should be as low as possible and if you have major portion as fixed cost, then it will give you more profits if the company can achieve more sales.
Vinu How that works?
Manu If you have more fixed cost, then it means you have less variable cost.
Vinu Yes!
Manu If you subtract variable cost from sales, you will get contribution.
Vinu Yes!
Manu Understand, contribution is called as contribution, because it only contributes to pay your fixed cost, tax and profits to the owners.  6
Vinu True! True!
Manu So, the message is if you have more contribution and if you have more fixed cost, you tend to make more profits.
Vinu Only this point buzzes me.

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

Manu It is because, when your contribution increases with increase in sales, fixed cost would stand fixed. It is not going to increase. So you have more contribution and less fixed cost. Hence, obviously more profits.

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

Vinu Ok! Ok!
Manu But you have to be very careful with Fixed Cost. The cost structure of the company should be dependent on business environment.
Vinu Why’s that?
Manu If the business environment is very conducive and if there is scope for achieving growth in sales, then business entities can take more fixed cost.

 

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.

Vinu Yes!

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

So we can have more profits!

Manu Exactly!

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.

Vinu Correct!

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

Manu Yes!

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

Vinu Ok! Let me tabulate

Particular Existing 30% drop in sales
Sales 100 70
Variable cost 50 35
Fixed Cost 40 40
Profits 10 -5
Manu Look at that!

 

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!

Vinu So Fixed Cost is double sided weapon!
Manu Yes! It can work for you in good times and work against you in bad times!
Vinu But where is the concept of leverage here?
Manu Fine. Let me introduce you the leverage concepts.

 

For that we have to split fixed costs further!

Vinu Like?
Manu Fixed Costs into

a)  Operating Fixed Cost

b)  Non-Operating Fixed Cost

Vinu Should I break our cost numbers?
Manu Do it please for Rs.100 Crs Sales.
Vinu
Particulars Amount
Sales 100
Variable cost 50
Fixed Cost 40
Profits 10

 

This one?

Manu Yes!
Vinu
Particulars Amount
Sales
Variable cost
Contribution  
Operating Fixed Cost
EBIT  
Non-Operating Fixed Cost
Profits  
Manu Perfect!

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

Vinu Yes!
Manu Now look at your Contribution. It is 50% of Sales.
Vinu Yes!
Manu Understand, contribution is something, which you can get at the same level comparable with other players in Industry. Because, it is decided by Sales and Variable Cost which may be common for everyone in the industry.
Vinu Like?
Manu Like Selling Price, Raw Material Cost and other Variable Costs.
Vinu Ok!
Manu Your ability to make profit is decided by your Fixed Costs after Contribution.

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

Why did this happened?

Vinu Because of Operating Fixed Cost of Rs.20 Crs.
Manu Yes!

This tells us about Operating Leverage.

Your Operating Fixed Cost determines Operating Leverage.

Vinu Oh!
Manu Your Contribution was Rs.50 Crs whereas EBIT was Rs.30 Crs. It means, your Contribution was 1.67 Times of EBIT.
Vinu Yes.

Contribution / EBIT = 50/30 = 1.67 Times.

Manu Exactly and this is the computation for Operating Leverage!
Vinu But what does that communicate?
Manu It means, when your sales increases by 1 Time, your EBIT will increase by 1.67 Times.
Vinu That’s great! I want to check that!
Manu Try when your sales increases to 200 Crs
Vinu Ok!

Particulars Existing Proposed
Sales 100 200
Variable cost 50 100
Contribution 50 100
Operating Fixed Cost 20 20
EBIT 30 80
Manu Look at your EBIT growth.
Vinu Yes! EBIT has grown by 50 (80 – 30).

 

50/30 = 1.67 Times.

 

EBIT has grown by 1.67 Times.

 

Exactly as provided by Operating Leverage.

Manu Yes Vinu!

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!

Vinu Acha!!
Manu So, if your Operating Leverage is high, it would mean you have higher fixed cost. So if your sales

increases, your EBIT will grow by Operating Leverage Multiples.

Vinu True!
Manu But what is more important for the investors is EBT and not EBIT.
Vinu Yes! Now I could follow!

 

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

 

Is that right?

Manu Yes!

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.

Vinu Let me put up the numbers.
Manu Please do it.
Vinu
Particulars Amount
Sales 100
Variable cost 50
Contribution 50
Operating Fixed Cost 20
EBIT 30
Non-Operating Fixed Cost 20
Earnings before Tax (EBT) 10
Manu Above table says, your EBIT was 3 Times of EBT.
Vinu True.

EBIT/EBT = 30/10 = 3 Times

Manu This is called Financial Leverage.
Vinu What’s the impact?
Manu It says, 2/3rd  of your EBIT was eaten away by Non-Operating Fixed Costs.

 

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

Vinu Shall I check that with our table?
Manu Please! Check what will be the effect on your EBT, when your EBIT increases due to increase in

sales to Rs.200 Crs.

Vinu
Particulars Existing Proposed
Sales 100 200
Variable cost 50 100
Contribution 50 100
Operating Fixed Cost 20 20
EBIT          30 80
Non-Operating Fixed Cost 20 20
EBT 10 60
Manu Look at your growth in EBIT.

It had grown from 30 to 80.

Growth by 50.

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

Vinu Yes! We have discussed this already! Operating leverage will tell us the growth in EBIT in times.
Manu Yes.

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

 

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

Vinu Oh!!
Manu What was your existing EBT?
Vinu Rs.10 Crs
Manu As per Financial Leverage, your EBT should grow by 5 Times. i.e., 10 x 5 = 50
Vinu Yesss!!!

It had grown to Rs.60 Crs.

i.e., 10 + 50 = 60

Manu That’s the job of Financial Leverage. It will tell you, how your EBT will react, when your sales changes.

 

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.

Vinu Can we know the effect on EBT for change in Sales directly?
Manu Yes!

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

Vinu How that is derived?
Manu Contribution / EBT gives you combined leverage.

 

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

Vinu It means, Contribution / EBT = 50 /10 = 5 Times is the Combined Leverage.
Manu Yes!

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

Vinu Let me check!

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)

Manu It would match.

 

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.

Vinu Wonderful!
Manu This might look like simple computation.

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.

Vinu True!
Manu It helps management to understand how their profits will react to change in sales.

 

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.

Vinu Correct!
Manu Similarly, if financial leverage is high, they can make more profits when their sales increases.

 

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.

Vinu Yes Manu!
Manu To conclude,

 

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.

Vinu Yes Manu!

 

Now I could understand the importance of Leverage.

 

Thank you! But the session got a bit lengthier!

Manu If you have to understand something, you should spend some time. But I am sure, it is worth spending.
Vinu Yes Manu!

Thank you very much.

N Raja CA, A Practicing Chartered Accountant with tonnes of passion for teaching. He also holds a PGDBA – Finance from Symbiosis SCDL and a B.Com., from Loyola College, Chennai. Read More.

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