Analysis on leverage

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!

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

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!

Manu

Now it’s time to split your costs!

Vinu

Like?

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

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

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!

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

???

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 yourexistingcosts?

Vinu

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

Manu

Look at your profit!

Vinu

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

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

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.

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

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

1. Operating Fixed Cost
2. Non-Operating Fixed Cost

Vinu

Should I break our cost numbers?

Manu

Do it please for Rs.100 Crs Sales.

Vinu

This one?

Manu

Yes!

Vinu

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!

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

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

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.