Operating and

Financial Leverage
Block, Hirt, and Danielsen

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Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
 Chapter Outline
What is leverage?
Break-even analysis
Operating leverage
Financial leverage
Combined leverage
Potential profits or increased risk?

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 What is Leverage?
Use of special forces or effects to magnify or produce more
than normal results from given course of action
Can produce beneficial results in favorable
conditions
Can produce highly negative results in
unfavorable conditions

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 Leverage in a Business
Determining type of fixed operational costs
Plant and equipment
Eliminates labor in production of inventory
Expensive labor
Lessens opportunity for profit but reduces risk exposure
Determining type of fixed financial costs
Debt financing
Substantial profits but failure to meet contractual obligations can result in
bankruptcy
Selling equity
Reduces potential profits but minimizes risk exposure

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 Operating Leverage
Extent to which fixed assets and associated fixed costs are
utilized in business
Operational costs include
Fixed
Variable
Semi-variable

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 Break-Even Chart: Leveraged Firm

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 Break-Even Analysis
Break-even point is 50,000 units, where total costs and total
revenue lines intersect

Units = 50,000
Total Variable Costs Fixed Costs Total Costs Total Revenue Operating Income
(TVC) (FC) (TC) (TR) (Loss)

(50,000 x $0.80) $60,000 $100,000 (50,000 x $2) $0

$40,000 $100,000

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 Break-Even Analysis

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 Volume-Cost-Profit Analysis:
Leveraged Firm

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 A Conservative Approach
Some firms choose not to operate at high degrees of operating
leverage
More expensive variable costs may be substituted for automated
plant and equipment
May cut into potential profitability of firm

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 Break-Even Chart
Conservative Firm

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 Volume-Cost-Profit Analysis:
Conservative Firm

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 The Risk Factor
Factors influencing decision on maintaining conservative or
leveraged position include

- Economic condition
- Competitive position within industry
- Future position – stability versus market leadership
- Matching acceptable return with desired risk level

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 Cash Break-Even Analysis
Deals with cash flows rather than accounting flows
Helps in analyzing short-term outlook of firm
Examples of excluded noncash items
Depreciation
Credit sales
Credit purchase of materials

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 Degree of Operating Leverage
(DOL)
Percentage change in operating income as result of percentage
change in units sold
Computed only over profitable range of operations
More when computed closer to basic earning power (BEP)

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 Operating Income or Loss

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 Algebraic Formula for DOL

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 Limitations of Analysis
Assumes existence of constant or linear function for revenues
and costs as volume changes
May not hold well in real world
Price weakening to capture increasing market
Cost overruns when moved beyond optimum-size
operation
Relationships not so fixed as assumed

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 Nonlinear Break-Even Analysis
Assumption of exact linear relationship does not hold well in
reality

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 Financial Leverage
Reflects amount of debt used in capital structure of firm
Determines how to finance operation
Determines performance between two firms with equal
operating capabilities

BALANCE SHEET
Assets Liabilities and Net Worth
Operating Leverage Financial Leverage

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 Impact on Earnings
Examine two financial plans for firm where $200,000 is required
to carry assets

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 Impact of Financing Plan on Earnings
per Share

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 Financing Plans and Earnings
per Share

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 Degree of Financial Leverage

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 Limitations to Use
of Financial Leverage

Beyond a point, debt financing is detrimental to firm

Lenders will perceive greater financial risk
Common stockholders may drive down price
Debt recommended for firms
In generally stable industry
In positive growth stage
Operating in favorable economic conditions

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 Combining Operating
and Financial Leverage

Combined leverage— when both leverages allow firm to

maximize returns
Operating leverage
Affects asset structure of firm
Determines return from operations
Financial leverage
Affects debt-equity mix
Determines how benefits received are allocated

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 Combined Leverage Influence
on the Income Statement

Last item under operating leverage, operating income, becomes initial

item for determining financial leverage
“Operating income” and “Earnings before interest and taxes” are the
same, representing return to owners before interest and taxes are paid

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 Combining Operating
and Financial Leverage

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 Operating and Financial
Leverage

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 Degree of Combined Leverage

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 Degree of Combined Leverage

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