Leverage Analysis: Operating, Financial and Combined Leverage, EBIT-EPS (Basics) Questions

Question 1

Define operating leverage.

Accepted Answer

Operating leverage is the use of **fixed operating costs** that causes a larger change in **EBIT** for a given change in sales.

Question 2

Define financial leverage.

Accepted Answer

Financial leverage is the use of **fixed financial charges** (interest) that causes a larger change in **EPS** for a given change in EBIT.

Question 3

What is DOL?

Accepted Answer

DOL (Degree of Operating Leverage) measures sensitivity of **EBIT** to changes in sales.

Question 4

Write the basic formula of DFL.

Accepted Answer

Basic formula: **DFL = EBIT / (EBIT − Interest)** (ignoring preference dividend and taxes in basic form).

Question 5

What is combined leverage (DCL)?

Accepted Answer

Combined leverage (DCL) measures sensitivity of **EPS** to changes in sales and is given by **DCL = DOL × DFL**.

Question 6

Higher leverage always means lower risk.

Accepted Answer

False. Higher leverage increases **risk** because profits/EPS become more sensitive to changes in sales or EBIT.

Question 7

Differentiate between operating leverage and financial leverage (any three points) using a table.

Accepted Answer

Operating vs financial leverage:

| Basis | **Operating leverage** | **Financial leverage** |
|---|---|---|
| Cause | **fixed operating costs** | **interest/fixed finance charges** |
| Sensitivity | EBIT to sales | EPS to EBIT |
| Risk type | **operating risk** | **financial risk** |

Thus, operating leverage is business risk; financial leverage is financing risk.

Question 8

Compute DOL: Contribution ₹4,00,000 and EBIT ₹1,00,000.

Accepted Answer

DOL = **Contribution / EBIT**

= 4,00,000 / 1,00,000 = **4**.

| Contribution | EBIT | **DOL** |
|---:|---:|---:|
| 4,00,000 | 1,00,000 | **4** |

Question 9

Compute DFL: EBIT ₹2,00,000 and interest ₹50,000.

Accepted Answer

DFL = **EBIT / (EBIT − Interest)**

= 2,00,000 / (2,00,000 − 50,000)
= 2,00,000 / 1,50,000 = **1.33** (approx.)

| EBIT | Interest | **DFL (approx.)** |
|---:|---:|---:|
| 2,00,000 | 50,000 | **1.33** |

Question 10

Compute DCL if DOL = 3 and DFL = 2. Interpret the result.

Accepted Answer

DCL = **DOL × DFL** = 3 × 2 = **6**.

Interpretation: A 1% change in sales will cause about **6% change in EPS** (approx.), so risk/variability is high.

| DOL | DFL | **DCL** |
|---:|---:|---:|
| 3 | 2 | **6** |

Question 11

Explain the relationship between DOL, DFL and DCL with a small table.

Accepted Answer

Relationship:

- **DCL = DOL × DFL**
- DOL captures operating (business) risk; DFL captures financing risk.

| Measure | Sensitivity of | Basic formula |
|---|---|---|
| **DOL** | EBIT to sales | Contribution/EBIT |
| **DFL** | EPS to EBIT | EBIT/(EBIT−Interest) |
| **DCL** | EPS to sales | **DOL×DFL** |

Thus, total risk combines operating and financial effects.

Question 12

Compute contribution and EBIT, then DOL: Sales ₹8,00,000; variable cost ₹5,00,000; fixed cost ₹2,00,000.

Accepted Answer

Contribution = Sales − Variable cost = 8,00,000 − 5,00,000 = **₹3,00,000**.

EBIT = Contribution − Fixed cost = 3,00,000 − 2,00,000 = **₹1,00,000**.

DOL = **Contribution/EBIT** = 3,00,000/1,00,000 = **3**.

| Item | Amount (₹) |
|---|---:|
| Contribution | **3,00,000** |
| EBIT | **1,00,000** |
| **DOL** | **3** |

Question 13

Explain EBIT–EPS analysis and its usefulness in financing decisions (exam-style) with a flow/table.

Accepted Answer

### Meaning
EBIT–EPS analysis compares alternative financing plans (more **debt** vs more **equity**) by computing EPS at different EBIT levels.

### Steps (flow)
EBIT → Less: **Interest** → EBT → Less: **Tax** → EAT → Divide by equity shares → **EPS**

| What it shows | Interpretation |
|---|---|
| EPS under Plan A vs Plan B | choose plan with higher EPS at expected EBIT |
| Sensitivity | debt plan has higher **financial risk** |

### Conclusion
It helps select a capital structure that balances **risk–return** and improves EPS for expected operating performance.

Question 14

Explain operating leverage, financial leverage and combined leverage with formulas and risk interpretation (exam-style).

Accepted Answer

### Operating leverage (DOL)
Arises due to **fixed operating costs**.
DOL = **Contribution/EBIT**.
Higher DOL → higher **operating risk**.

### Financial leverage (DFL)
Arises due to **interest/fixed finance charges**.
DFL = **EBIT/(EBIT − Interest)**.
Higher DFL → higher **financial risk**.

### Combined leverage (DCL)
Captures total sensitivity of EPS to sales.
DCL = **DOL × DFL**.

| Leverage | Cause | Risk |
|---|---|---|
| **DOL** | fixed operating costs | operating risk |
| **DFL** | interest/fixed charges | financial risk |
| **DCL** | both | total risk |

### Conclusion
Higher leverage increases potential return but also increases variability of profits/EPS.

Question 15

A firm is considering higher debt. Explain how financial leverage affects EPS and risk (include a small table) (exam-style).

Accepted Answer

### Effect on EPS
With more **debt**, interest becomes a fixed charge. If EBIT is high enough, interest is covered and EPS can increase because equity is smaller.

### Effect on risk
When EBIT falls, interest still has to be paid, so EPS falls sharply → higher **financial risk**.

| EBIT situation | High-debt plan | Risk outcome |
|---|---|---|
| High EBIT | EPS may be **higher** | acceptable risk |
| Low EBIT | EPS becomes **lower** | high risk due to fixed interest |

### Conclusion
Financial leverage increases EPS potential but also increases EPS variability; decisions should consider expected EBIT and risk tolerance.

Basis	Operating leverage	Financial leverage
Cause	fixed operating costs	interest/fixed finance charges
Sensitivity	EBIT to sales	EPS to EBIT
Risk type	operating risk	financial risk

Leverage Analysis: Operating, Financial and Combined Leverage, EBIT-EPS (Basics)

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