Leverage is defined as the risk-taking capacity of the organization that how much risk the company can bear in a given period of time, the risk here means the paying back the interest amount on the financial loans and paying the operating or fixed expenses of a company.

According to **J. C. Van Home** “Leverage is the employment of an asset or funds for which the firm pays a fixed cost of fixed return.”

Types of Leverages: -

- Operating Leverage
- Financial Leverage
- Combined Leverage

Operating leverage is the cost of fixed asset procured by a company and the operating fixed costs of a company that incurred in the day to day activities such as repairs and maintenance, depreciation, insurance of assets, property taxes etc.

The formula for calculating the operating leverage or the operating leverage ratio is:-

**The degree**** of operating leverage**= percentage change in EBIT/ percentage change in Sales

Percentage change in EBIT= Increase in EBIT/EBIT

Percentage change in Sales = Increase in Sales/ Sales

The degree of operating leverage can also be computed as

**DOL** **= Contribution / EBIT**

**Higher** is the degree of operating leverage, the **better** it is.

If the value of the degree of operating leverage is **1** it means there is no operating leverage or operating risk in the company.

**For Example 1:-**

Calculate degree of operating leverage from the following :-

Sales - $100,000

Variable cost - $ 30,000

Fixed cost - $ 10,000

**Solution** –

Sales = $100000

Variable cost = $30000

Contribution = Sales – Variable cost

**Contribution = $70000**

EBIT (Earning before interest and tax) = Contribution – Fixed cost

EBIT = $70000- $10000

**EBIT = $60000**

Degree of operating leverage = Contribution / EBIT

DOL = $ 70000/ $ 60000

**DOL = 1.167**

Example 2:-

Calculate the degree of operating leverage from the following:-

Sales in 2018 were $150000 and Sales in 2019 is $250000, EBIT in 2018 was $10000 and EBIT in 2019 is $15000. Compute DOL.

**Solution -**

**Degree of Operating Leverage = % change in EBIT/ % change in Sales **

% change in EBIT= increase in EBIT/ EBIT

% change in EBIT = $5000/$10000

**% change in EBIT = 50%**

% change in Sales = Increase in Sales / Sales

% change in Sales = $100000/$150000

**% change in Sales = 66.67%**

DOL = % change in EBIT / % change in Sales

DOL = 50%/66.67%

**DOL = 0.75**

Financial leverage is the cost of interest incurred on financial capital raised from the market by the company.

The formula for calculating the financial leverage or the financial leverage ratio is:-

**The degree**** of financial leverage**= percentage change in EPS/ percentage change in EBIT

Percentage change in EPS= Increase in EPS/EPS

Percentage change in EBIT= Increase in EBIT/EBIT

Degree of financial leverage can also be computed as

**DFL** = EBIT / EBIT – Interest – preference dividend (if any)

**DFL** **= EBIT/ EBT**

**Lower** the financial leverage ratio the **better** it is.

This shows the company is having a lower amount of debt.

**Example 3 :-**

Calculate degree of financial leverage from the following :-

Sales - $100,000

Variable cost - $ 30,000

Fixed cost - $ 10,000

Interest on 10% Debenture of $ 100,000

**Solution** –

Sales = $100000

Variable cost = $30000

EBIT (Earnings before interest and tax) = Sales – Variable cost – fixed cost

EBIT (Earnings before interest and tax) = $100000- $30000 - $ 10000

**EBIT = $60,000**

EBT (Earnings before tax) = EBIT – interest on debenture

EBT = $60,000- $10,000

**EBT = $50,000**

**DFL= EBIT/EBT**

DFL= $60,000/$50,000

**DFL = 1.2**

Example 4:-

Calculate the degree of financial leverage from the following:-

EPS in 2018 was $15 and the EPS in 2019 is $25, EBIT in 2018 was $10000 and EBIT in 2019 is $15000. Compute DFL.

**Solution –**

**Degree of Financial Leverage = % change in EPS/ % change in EBIT**

% change in EBIT= increase in EBIT/ EBIT

% change in EBIT = $5000/$10000

**% change in EBIT = 50%**

% change in EPS = Increase in EPS / EPS

% change in EPS = $10/$15

**% change in EPS = 66.67%**

DFL = % change in EPS / % change in EBIT

DFL = 66.67% / 50%

**DFL = 1.33**

**EXAMPLE 5:-**

Calculate the Degree of financial leverage ratio from the following data of ABC company (UK) :-

Sale = $200,000

Variable cost = $ 100,000

Fixed cost = $ 20,000

10% debentures of $ 100,000 and 10% preference shares of $ 200,000 are borrowed from the market.

**Solution –**

EBIT (Earnings before interest and tax) = Sales – Variable cost – Fixed cost

EBIT= $200,000 - $ 100,000 - $ 20,000

**EBIT = $ 80,000**

EBT (Earnings before tax) = EBIT – Interest on debenture – preference dividend

EBT = $80,000 - $10,000 - $ 20,000

**EBT = $ 50,000**

DFL = EBIT/EBT

DFL = $80,000/ $50,000

**DFL = 1.6**

** **

The degree of combined leverage is the combined effect of the operating leverage ratio and financial leverage ratio. It shows the effect of a change in sales on the change of earning EPS share.

The formula for calculating the combined leverage or the combined leverage ratio is:-

**The degree**** of combined leverage**= percentage change in EPS/ percentage change in Sales

Percentage change in EPS= Increase in EPS/EPS

Percentage change in Sales = Increase in Sales/ Sales

Degree of combined leverage can also be computed as

**DCL** = Sales – Variable cost / EBIT – Interest – preference dividend (if any)

**DCL** **= Contribution / EBT**

DCL = DOL* DFL

**Lower** the combined leverage ratio the **better** it is.

This shows the amount of fixed cost and amount of financial debt that the company is having in the given period of time.

Example 6 :-

Calculate the Degree of combined leverage ratio from the following data of XYZ company (UK) :-

Sale = $200,000

Variable cost = $ 100,000

Fixed cost = $ 20,000

10% debentures of $ 100,000 and 10% preference shares of $ 200,000 are borrowed from the market.

**Solution –**

Contribution = Sales – Variable cost

Contribution = $ 200,000 - $ 100,000

Contribution = $ 100,000

EBT (Earnings before tax) = Contribution – Fixed cost – Interest on debenture – Preference dividend

EBT= $ 100,000 - $20,000 - $10,000 -$ 20,000

**EBT = $ 50,000**

DCL = Contribution / EBT

DCL = $100,000/ $50,000

**DCL = 0.5**

Example 7:-

Calculate the Degree of operating leverage, Degree of Financial Leverage and Degree of combined leverage from the following given data:-

Sales = $500,000

Variable cost = $ 200,000

Fixed cost = $ 100,000

The company is having 10% debentures of $ 200,000 and 10% preference shares of $ 300,000.

**Solution**: -

**Calculation of Degree of Operating Leverage -**

DOL= Contribution / EBIT

Contribution = Sales – Variable cost

Contribution = $500,000 - $ 200,000

**Contribution = $ 300,000**

EBIT (Earnings before Interest and Tax) = Contribution – Fixed cost

EBIT = $ 300,000 - $ 100,000

EBIT = $ 200,000

**DOL = Contribution / EBIT**

DOL = $ 300,000/ $200,000

**DOL = 1.5**

**Calculation of Degree of Financial Leverage –**

**DFL = EBIT / EBT**

**EBIT = $ 200,000**

EBT (Earnings before tax) = EBIT – Interest on debenture – Preference dividend

EBT = $200,000 - $ 20,000 - $ 30,000

**EBT = $ 150,000**

**DFL = EBIT / EBT**

DFL = $200,000/ $ 150,000

**DFL = 1.33**

**Calculation of Degree of Combined Leverage -**

**DCL = DOL * DFL**

DCL = 1.5 * 1.33

**DCL = 1.99**

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