What is Leverage & Operating Leverages – Introduction
Leverage & Operating Leverages: Operation of a firm can be run by using different means of finances like preference shares, equity shares, and retained earnings or with debts. In general, a firm uses a combination of different financial instruments. All these different financial instruments make the capital structure of a firm. Capital structure refers to debt to equity ratio, which gives vision to a firm about the risk of capital structure and effect on the profitability of firm together with different factors, like a failure of profitability, cost of capital, the market value of the firm. Further using debt or leverage also increase risk the firm to bankruptcy. It also increases the return of the company especially returns on equity. This is just because of non-increment of the issue of more equity shares, leads to non-dilution of earnings per equity share as the debt financing will prohibit getting finances by issuing more number of equity shares. Hence it can be drawn out from the above introduction that debts financing up to an optimum level is good for the firm and increases the profitability of the firm.
Basically, there are three types of the leverages. – Operating Leverages, Financial Leverages, and Capital and Working Capital Marketing.
The use of assets for which a company pays a fixed cost is called operating leverage. Elaborately it refers to fixed cost invested in assets with an expectation to generate sufficient revenue to cover fixed and variable costs.
Formula for calculation of the degree of operating leverage = Contribution / Earning before interest and tax
BREAK EVEN ANALYSIS AND OPERATING LEVERAGE
Break-even is a position where the firm arrives as no profit and no loss situation. Or we can say a situation where contribution happens equally to be fixed cost. In terms of totality total cost becomes equal to total revenue. This is also called cost volume profit analysis. And this technique also used to determine possible profit loss at any given level of production or sale.
Breakeven point in unit terms can be calculated the fixed cost by contribution per unit. This will give a number of units to be produced to cover the fixed cost incurred.
There are some more ways to find out the degree of operating leverage which is as under:
Degree of operating leverage can be calculated by dividing percentage change in EBIT by percentage change in sales. If DOL is more than 1 than operating leverage exists more is a degree of operating leverage higher is operating leverage. If a firm operating leverage is positive than firm is said to be operating at a higher level than breakeven point. If the case is opposite and DOL is negative than the firm is said to be operating at a lower level than break even and the EBIT of the firm is negative.
Analysis of operating leverage :
- If there is no fixed cost in the firm no operating leverage will exist.
- Higher fixed cost higher will be the breakeven point.
- Higher than Break-Even Level than Positive Operating Leverage and vis a vis.
This is all about operating leverage. I hope that all CA Intermediate students will get a great help to develop the learning about operating leverage with the help of this article. For the further and deep learning please visit the website www.takshshilaelearning.com which approaches you to make you learn the concepts of the courses as per your choice.
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