Topic 7 Analysis and Impact

of Leverage

Operating Leverage
Financial Leverage

What is Leverage?

What is Leverage?
In general ,leverage refers to accomplish
certain things which are otherwise not
possible i.e. lifting of heavy objects with the
help of lever. This concept of leverage is
valid in business also .

In finance ,the term leverage is used to describe the firms ability to use
fixed cost assets or funds to increase the return to its owners; i.e. equity
shareholders. In other words, the fixed cost funds i.e. debentures &
preference share capital act as the fulcrum , which assist the lever i.e. the
firm to lift i.e. to increase the earnings of its owner i.e. the equity
shareholders.
If earnings less the variable costs exceed the fixed costs i.e. preference
dividend & interest on debenture, or earnings before interest and taxes
exceed the fixed return requirement, the leverage is called favorable . when
they do not ,the result is unfavorable leverage .
Leverage is also the influence which an independent variable has over a
dependent/related variable i.e. rainfall over production. In financial context,
sales & fixed cost over profit

Two concepts that enhance our

understanding of risk...
1) Operating Leverage - affects a
firms business risk by USING
fixed operating costs by the firm.
2) Financial Leverage - affects a
firms financial risk by use of
fixed financing costs by the firm. gearing.

Business Risk

The variability or uncertainty of a

firms operating income (EBIT).

Business Risk

The variability or uncertainty of a

firms operating income (EBIT).

EBIT

FIRM

EPS

Stockholders

Business Risk
Affected by:
Sales volume variability
Competition
Product diversification
Operating leverage
Growth prospects
Size

Operating Leverage

The use of fixed operating costs as

opposed to variable operating
costs.
A firm with relatively high fixed
operating costs will experience
more variable operating income if
sales change.

EBIT
Operating
Leverage

Financial Risk

The variability or uncertainty of

a firms earnings per share (EPS)
and the increased probability of
insolvency that arises when a
firm uses financial leverage.

Financial Risk

The variability or uncertainty of

a firms earnings per share (EPS)
and the increased probability of
insolvency that arises when a
firm uses financial leverage.
EBIT

FIRM

EPS

Stockholders

Financial Leverage

The use of fixed-cost sources of

financing (debt, preferred stock)
rather than variable-cost sources
(common stock).

EPS
Financial
Leverage

Breakeven Analysis
Illustrates the effects of operating

leverage.
Useful for forecasting the profitability
of a firm, division, or product line.
Useful for analyzing the impact of
changes in fixed costs, variable costs,
and sales price/volume and profits.
Also called cost/volume/profit (C/V/P)
analysis

Breakeven Analysis
$

Quantity

Total Revenue

Quantity

Costs
Suppose the firm has both fixed
operating costs (administrative
salaries, insurance, rent, property
tax) and variable operating costs
(materials, labor, energy,
packaging, sales commissions).

Total Revenue

Quantity

Total Revenue

Total Cost

FC {
Quantity

Total Revenue

Total Cost

FC {

}
profits EBIT

losses

Q1

Quantity

Total Revenue

Total Cost

} EBIT

profits

FC {

losses

Break-even
point

Q1

Quantity

Operating Leverage
What happens if the firm
increases its fixed operating
costs and reduces (or
eliminates) its variable costs?

Total Revenue

Total Cost

FC {

}
profits EBIT

losses

Breakeven
point

Q1

Quantity

Total Revenue

EBIT
profits

FC

Total Cost
= Fixed

losses

Break-even
point

Q1

Quantity

With high operating leverage,

an increase in sales
produces a relatively larger
increase in operating
income.

Total Revenue

$
profits

FC

losses

Breakeven
point

Q1

EBIT
Total Cost
= Fixed
Quantity

Total
Revenue
Trade-off:

the firm has

a higher breakeven
EBIT
point. If sales
are not
+
high enough, the firm
will not meet
its fixed
Total
Cost
expenses!
= Fixed

FC

Breakeven
point

Q1

Quantity

Breakeven Calculations
Breakeven point (units of output)

QB =

F
P-V

QB = breakeven level of Q.
F = total anticipated fixed costs.
P = sales price per unit.
V = variable cost per unit.

Breakeven Calculations
Breakeven point (sales dollars)

S* =

F
VC
1S

S* = breakeven level of sales.

F = total anticipated fixed costs.
S = total sales.
VC = total variable costs.

Analytical Income Statement

-

sales
variable costs
fixed costs
operating income (EBIT)
interest
EBT
taxes
net income

Degree of Operating
Leverage (DOL)

Operating leverage: by using fixed

operating costs, a small change in
sales revenue is magnified into a
larger change in operating income.

This multiplier effect is called

the degree of operating leverage.

Degree of Operating Leverage

from Sales Level (S)

DOLs =

% change in EBIT
% change in sales

Degree of Operating Leverage

from Sales Level (S)

DOLs =

% change in EBIT
% change in sales
change in EBIT
EBIT
change in sales
sales

Degree of Operating Leverage

from Sales Level (S)

If we have the data, we can use this formula:

Sales - Variable Costs

DOLs =
EBIT
=

Q(P - V)
Q(P - V) - F

What does this tell us?

If DOL = 2, then a 1% increase in
sales will result in a 2% increase in
operating income (EBIT).

What does this tell us?

If DOL = 2, then a 1% increase in
sales will result in a 2% increase in
operating income (EBIT).

Sales

EBIT

EPS

Stockholders

Degree of Financial
Leverage (DFL)

Financial leverage: by using fixed

cost financing, a small change in

operating income is magnified into
a larger change in earnings per
share.

This multiplier effect is called

the degree of financial leverage.

Degree of Financial Leverage

DFL =

% change in EPS
% change in EBIT

Degree of Financial Leverage

DFL =

% change in EPS
% change in EBIT
change in EPS
EPS
change in EBIT
EBIT

Degree of Financial Leverage

If we have the data, we can use this formula:

EBIT
DFL =
EBIT I P(1-t)

What does this tell us?

If DFL = 3, then a 1% increase in
operating income will result in a 3%
increase in earnings per share.

What does this tell us?

If DFL = 3, then a 1% increase in
operating income will result in a 3%
increase in earnings per share.

Sales

EBIT

EPS

Stockholders

Degree of Combined
Leverage (DCL)

Combined leverage: by using operating

leverage and financial leverage, a small
change in sales is magnified into a larger
change in earnings per share.

This multiplier effect is called the

degree of combined leverage.

Degree of Combined Leverage

DCL = DOL x DFL
% change in EPS
=
% change in Sales

Degree of Combined Leverage

DCL = DOL x DFL
% change in EPS
=
% change in Sales

change in EPS
EPS
change in Sales
Sales

Degree of Combined Leverage

If we have the data, we can use this formula:

Degree of Combined Leverage

If we have the data, we can use this formula:

DCL =

Sales - Variable Costs

EBIT - I
Q(P - V)
Q(P - V) - F - I

What does this tell us?

If DCL = 4, then a 1% increase in sales
will result in a 4% increase in earnings
per share.

What does this tell us?

If DCL = 4, then a 1% increase in sales
will result in a 4% increase in earnings
per share.

Sales

EBIT

EPS

Stockholders

In-class Project:
Based on the following information on
Levered Company, answer these
questions:
1) If sales increase by 10%, what should
happen to operating income?
2) If operating income increases by 10%,
what should happen to EPS?
3) If sales increase by 10%, what should be
the effect on EPS?

Levered Company
Sales (100,000 units)
Variable Costs
Fixed Costs
Interest paid
Tax rate
Common shares outstanding

$1,400,000
$800,000
$250,000
$125,000
34%
100,000

Levered Company

Sales

Operating
Income

Operating
leverage

Financial
leverage

EPS

Degree of Operating Leverage

from Sales Level (S)

Sales - Variable Costs

DOLs =
EBIT

Degree of Operating Leverage

from Sales Level (S)

Sales - Variable Costs

DOLs =
EBIT
=

1,400,000 - 800,000
350,000

Degree of Operating Leverage

from Sales Level (S)

Sales - Variable Costs

DOLs =
EBIT
=

1,400,000 - 800,000
350,000

= 1.714

Levered Company

Sales

Operating
Income

EPS

Levered Company

Sales

Operating
Income

Operating
leverage

EPS

Levered Company
10%

Sales

Operating
Income

Operating
leverage

EPS

Levered Company
17.14%

10%

Sales

Operating
Income

Operating
leverage

EPS

Degree of Financial Leverage

EBIT
DFL =
EBIT - I

Degree of Financial Leverage

EBIT
DFL =
EBIT - I
=

350,000
225,000

Degree of Financial Leverage

EBIT
DFL =
EBIT - I
=

350,000
225,000

= 1.556

Levered Company

Sales

Operating
Income

EPS

Levered Company

Sales

Operating
Income

Financial
leverage

EPS

Levered Company
10%

Sales

Operating
Income

Financial
leverage

EPS

Levered Company
15.56%

10%

Sales

Operating
Income

Financial
leverage

EPS

Degree of Combined Leverage

DCL =

Sales - Variable Costs

EBIT - I

Degree of Combined Leverage

DCL =
=

Sales - Variable Costs

EBIT - I
1,400,000 - 800,000
225,000

Degree of Combined Leverage

DCL =

Sales - Variable Costs

EBIT - I

1,400,000 - 800,000
225,000

2.667

Levered Company

Sales

Operating
Income

EPS

Levered Company

Sales

Operating
Income

Operating
leverage

EPS

Levered Company

Sales

Operating
Income

Operating
leverage

Financial
leverage

EPS

Levered Company
10%

Sales

Operating
Income

Operating
leverage

Financial
leverage

EPS

Levered Company
26.67%

10%

Sales

Operating
Income

Operating
leverage

Financial
leverage

EPS

Levered Company
26.67%

10%

Sales

Operating
Income

Operating
leverage

Financial
leverage

EPS

Levered Company
10% increase in sales

Sales (110,000 units)

Variable Costs
Fixed Costs
EBIT
Interest
EBT
Taxes (34%)
Net Income
EPS

1,540,000
(880,000)
(250,000)
410,000 ( +17.14%)
(125,000)
285,000
(96,900)
188,100
$1.881 ( +26.67%)

EXERCISE 1
As the financial manager for a manufacturing firm, you have
constructed the following partial pro forma income statement for the
next fiscal year.
Sales
$11,200,000
Variable costs
5,600,000
Revenue before fixed costs
5,600,000
Fixed costs
2,400,000
EBIT
3,200,000
Interest expenses
1,600,000
Earnings before taxes
1,600,000
Taxes (40%)
640,000
Net income
$ 960,000
a.
b.
c.
d.

What is the degree of operating leverage at this level of output?

What is the degree of financial leverage?
What is the degree of combined leverage?
What is the break-even point in sales dollars for the firm?

EXERCISE 2
The Basic Sports Company produces graphite surfcasting fishing rods. The average selling price for one
of their rods is $132. The variable cost per unit is
$80. Basic Sports has average fixed costs per year of
$90,000.
a. What is the break-even point in units for Basic
Sports?
b. What is the break-even point in dollar sales?

EXERCISE 3
The following is an analytical income statement for The Swill & Spoon,
a fine dining establishment:
Sales
$ 150,000
Variable costs
90,000
Revenue before fixed costs $ 60,000
Fixed costs
35,000
EBIT
$ 25,000
Interest expense
$ 10,000
Earnings before taxes
$ 15,000
Taxes (.34)
5,100
Net income
$ 9,900
a. Calculate the degree of operating leverage at this output level.
b. Calculate the degree of financial leverage at this level of EBIT.
c. What is the degree of combined leverage?