Leverage of Companies

Leverage of Companies

INTRODUCTION:

What’s degree of operating leverage?

            “It’s the Rate of change of Operating profit per unit change in sale”

            If Sales increase 10% and Operating profit increase by 20% then operating leverage is 2.

            20%

            —–= 2

            10%

            Companies having high Fixed cost have High operating leverage.

            E.g. Airlines, Telecom, mining.

            If there sales increase 10% their  Operating profit increase 30%

What is Financial Leverage?

            ” It’s the rate of change of PAT with rate of change of operating profit”

            If Operating profit increase 10% and PAT increase 20% then, financial leverage is 2.

            If company takes Huge loan, then it’s financial leverage is high.

Combined Leverage = Operating leverage x Financial leverage

            Combined leverage = PAT%/Sales%

What’s the significance of Leverage?

If company is using more Combined leverage, then it can be very volatile to business change. Share  Price can fluctuate drastically.

If you know the Leverage of companies you can predict Supports and Resistance of share price.  You need to combine technical and fundamental analysis here.

LESSONS LEARNT:

1. Fixed cost are expenses like Rent, Depreciation, Salary.

            Even if there is no sales. Cost is fixed.

            Variable cost means cost increases with per unit of products. .

2. At the start of bull market one can buy high leveraged company,  it runs fast.

At start of bear market buy low leverage company, they fall less

3. DE ratio is fixed till loan is paid. Its calculated from balance sheet

            Operating leverage changes with business. Its calculated from profit loss statement

4. Leverage is a business term that refers to how a business acquires new assets for startup or expansion.

Financial leverage calibrates total company financial risks while operating leverage measures business operating risk.

Merged together, combined leverage calculates total business risk.”

In general, high operating levels is a positive when company-wise sales rise, and they’re a negative when sales are in decline.

5. Financial Leverage:( Total Company’s financial risk )

            Firms do this when they are unable to raise enough capital by issuing shares in the market to meet their business needs.

            The biggest risk that arises from high financial leverage occurs when a company’s return on ROA does not exceed the interest on the loan, which greatly diminishes a company’s return on Equity and profitability.

A firm that operates with both high operating and financial leverage can be a risky investment. High operating leverage implies that a firm is making few sales but with high margins. This can pose significant risks if a firm incorrectly forecasts future sales.

There is no guarantee that financial leverage will produce a positive outcome. Basically, the higher the amount of debt a company uses as leverage, the higher – and the riskier – is its financial leverage position.

Also, the more leveraged debt a company absorbs, the higher the interest rate burden, which represents a financial risk to companies and their shareholders.

6. The Degree of Operating Leverage – DOL

            (The DOL ratio helps analysts determine what the impact of any change in sales will be on the company’s earnings.)

            The degree of operating leverage (DOL) is a multiple that measures how much the operating income of a company will change in response to a change in sales. Companies with a large proportion of fixed costs to variable costs have higher levels of operating leverage.

            The DOL ratio assists analysts in determining the impact of any change in sales on company earnings.

7. The Degree of Financial Leverage – DFL             This ratio indicates that the higher the degree of financial leverage, the more volatile earnings will be. Since interest is usually a fixed expense, leverage magnifies returns and EPS. This is good when operating income is rising, but it can be a problem when operating income is under pressure.