CAIIB ABFM Module B Unit 2 : Financial And Operating Leverages

05/10/2023

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CAIIB Paper 3 ABFM Module B Unit 2 : Financial And Operating Leverages (New Syllabus)

IIBF has released the New Syllabus Exam Pattern for CAIIB Exam 2023. Following the format of the current exam, CAIIB 2023 will have now four papers. The CAIIB Paper 3 (ADVANCED CONCEPTS OF FINANCIAL MANAGEMENT) includes an important topic called “Financial And Operating Leverages”. Every candidate who are appearing for the CAIIB Certification Examination 2023 must understand each unit included in the syllabus.

In this article, we are going to cover all the necessary details of CAIIB Paper 3 (ABFM) Module B (THE MANAGEMENT PROCESS) Unit 2 : Financial And Operating Leverages, Aspirants must go through this article to better understand the topic, Financial And Operating Leverages and practice using our Online Mock Test Series to strengthen their knowledge of Financial And Operating Leverages. Unit 2 : Financial And Operating Leverages

Financial Leverage

The owners of a business (equity shareholders), aim to enhance return on their investment.
The measure of this return is Earning Per Share (EPS).
When they conduct business without any debt, they achieve a certain EPS in the normal course of business.
If they bring more equity, the profit in absolute terms will increase but the EPS will remain the same.
Financial leverage means enhancing EPS without shareholders bringing money themselves but by borrowing.
Through debt, an organisation will acquire assets which will add value to the business.
The assumption here is that the cost of the borrowed funds will be less than the value added by these additional assets, purchased through the debt/borrowing

Calculating Financial Leverage

There is no one standard formula to calculate financial leverage. The important common methods to calculate it are as under:

Debt- to- Assets ratio: This is calculated as Total Debt/ Total Assets
Debt- to- Equity ratio: This is calculated as Total Debt/ Total Equity
Debt-to EBIDTA ratio: This is calculated as Total Debt /EBIDTA
Du-Pont analysis uses the “equity multiplier” as a measure of financial leverage. This is calculated as: Equity Multiplier = Total assets/ Total Equity
Interest Coverage ratio: This is calculated as EBIT/ Interest expense

Degree Of Financial Leverage And Its Behaviour

Financial leverage is a double edged sword.
It may enhance the return on equity and, beyond a point, affect it adversely too.
The fundamental rule of moderate, optimal or over use will apply here.
In a smaller scenario, the business can afford to go for use above optimal level since the risk or the loss, if any, being small can be controlled easily.
An optimal level is one which is just the right mix of equity and debt.
How one arrives at the ‘right’ is a matter of fact and realistic estimate of cost verses benefit, after the exercise of fund infusion is efficiently completed.
The businessman will estimate the value of business or assets once the borrowed funds are repaid and determine whether that level could have been achieved without the leverage.
A scientific conversion of modest, optimal and over use into numbers will give you the degrees of leverage.
In a large project, one has to adopt a cautious approach because risks too will be very high and above optimal leverage can prove to be disastrous.
For calculating the degree of financial leverage, we seek to establish correlation between the operating profit (EBIT) and the interest expense, which is assumed to be a fixed expense.

Degree of financial leverage is defined as ratio of percentage change in EPS and percentage change in EBIT, and can be mentioned as under:

∆EPS means change in EPS and
∆EBIT means change in EBIT.

This formula can be further refined in view of the fact that ∆EPS/ EPS is equal to ∆EBT/ EBT (as tax rate and number of shares, which correlate EPS and EBT are constants), as under:

DFL = ∆EBT/ EBT ∆EBIT/ EBIT
Further, any marginal change in EBT will be equal to same change in EBIT as interest (I) is assumed to be a fixed amount.
For example; if EBIT = Rs. 100 and I = Rs. 20, change in EBIT to Rs. 101 from 100 will result in change in EBT to Rs. 81 from Rs. 80. Therefore, ∆EBIT is equal to ∆EBT. So the above formula can be modified as;

ILLUSTRATION

A firm’s details are as under:

Sales (@100 per unit) Rs. 24,00,000

Variable Cost 50%

Fixed Cost Rs. 10,00,000

It has borrowed Rs. 10,00,000 @ 10% p.a. and its equity share capital is Rs. 10,00,000 (Rs. 100 each).

Consider tax @ 50%.

Calculate its Degree of Financial Leverage

Operating Leverage

As discussed above, in financial leverage, we establish a correlation between the fixed financial cost i.e. interest and the profit of the business.

In operating leverage, we consider other fixed expenses except interest and correlate these to the profit.

Consider the example of a wholesaler, who has got very low fixed costs but low contribution (difference between sales price and purchase price).

This business will be in profit even if the sales level comes down substantially as the fixed costs are quite low.

On the other hand, a business with high fixed cost like a hospital, will find any substantial drop in business to be disastrous even though the variable costs are low and consequently the contribution is high.

Degree Of Operating Leverage and Its Behaviour

The formula used is:

Degree of Operating Leverage (DOL) = % Change in EBIT/ % Change in Sales

Mathematically:

DOL = ∆ΕΒIΤ/ΕΒIT ∆ Sales Quantity/Sales Quantity

∆ Denotes change
This formula can be further refined in the light of the fact
EBIT = Sales quantity (Price per unit- variable cost per unit) – Fixed costs and, therefore,
∆ EBIT = ∆ Sales quantity (Price per unit- variable cost per unit) as the Fixed cost is a constant amount.

The rewritten formula will be:

Illustration 1: Calculate Degree of Operating Leverage when, a company

sells 1000 units of product X at Rs. 50
variable cost of Rs. 30 per unit and
fixed cost of Rs. 15,000.

Solution

Combined Or Total Leverage

This is a combination of financial and operative leverages. Here the fixed costsinclude both the operating fixed costs and financial fixed costs (interest). In such a situation, a marginal percentage change in revenue leads to disproportionate percentage change in EBT. For example, a 10% increase in revenue may increase EBT and consequently, the EPS by 15%. Similarly, a 10% fall in revenue may decrease EBT and consequently, the EPS by more than 10%. The following formula is used for calculating the degree of total leverage (DTL)

It is a product of both financial and operating leverages and can be written as:

DTL = DFL × DOL

= EBIT/EBT × Contribution/ EBIT

= Contribution/EBT

ILLUSTRATION

A firm has sales of Rs. 10,00,000, variable cost of Rs. 7,00,000 and fixed costs of Rs. 2,00,000 and debt of Rs. 5,00,000 at 10% rate of interest. What are the operating, financial and combined leverages?

SOLUTION:

ILLUSTRATION

Z Ltd has estimated that for a new product, the break-even point is 2,000 units, if the items are sold for Rs14 per unit. The Cost Accounting department has currently identified variable cost of Rs. 9 per unit. Calculate the degree of operating leverage for sales volume of 2,500 units and 3,000 units. What do you infer from the degree of operating leverage at the sales volumes of 2,500 units and 3,000 units and their difference if any?