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Degree ofleverage Leverage:, Operating, Financial and Total

Engineering Economy Universidad Tecnolgica de Bolvar Ignacio Vlez Pareja Professor http://www.cashflow88.com/
http://www.cashflow88.com/decisiones/decisiones.html

Thedegreeofleverageinafirmis calculatedbasedonvariousindexes. Somecommonindexesare: 1.Degreeofoperatingleverage,DOL 2.Degreeoffinancialleverage,DFL 3.Degree g oftotalleverage, g ,DTL

ivelez@unitecnologica.edu.co nachovelez@gmail.com Cartagena

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FinancialandRatioAnalysis. Vlez

7/16/2010

FinancialandRatioAnalysis. Vlez

OperatingLeverage
Operatingleverage isthedegree towhich c afirmusesfixed edcostsin itsoperations.Thehigherthe relativefixedcosts(%oftotal costs),thehigherthefirm's degreeofoperatingleverage.In firmswithhighdegreeof operatingleverage,asmall changeinrevenueswillresultina largerchangeinoperatingincome becausemostcostsarefixed.

VariableCosting
Q * USP Q * (UVC +UVE) FC FE = EBIT UPS = Unit Sales Price, UVC = unit variable cost, UVE = unit variable expense, FC = fixed costs, FE = Fixed expenses Q * [USP (UVC +UVE)] FC FE = EBIT

UCM

Fixed cost

CM

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DegreeofOperating LeverageDOL
Degreeofoperatingleverage (DOL)isthepercentagechangein EBIT,dividedbythepercentage changeinsales.Itisameasureof thesensitivityofEBITtochanges insalesduetochangesin operatingexpenses.

Degree ofoperating Leverage

DOL = EBIT Sales = MC EBIT

7/16/2010

FinancialandRatioAnalysis. Vlez

7/16/2010

FinancialandRatioAnalysis. Vlez

Apalancamiento Operativo
Sales Revenues - Variables Costs and expenses CONTRIBUTION MARGIN - Fixed Costs and expenses Earnings before Interest and Taxes (EBIT) - Interest expenses Earning before taxes (EBT) - Taxes Net Income

Example
Volume ou e o of Sa Sales es in units Unit Selling Price Unit variable cost Fixed Costs Sales &Adm. Fixed Expenses

20,000 $ 10 $6 $ 5,000 $ 3,500

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Effect on EBIT
Change in sales S l i Sales in units it Sales in $ Variable Costs Contribution Margin FC production GF A&V EBIT Impact on EBIT DOL 16 000 16,000 20% 20 000 20,000 24 000 24,000

160,000 200,000 240,000 96,000 120,000 144,000 64,000 5,000 3,500 55 500 55,500 -22.38% 1,12 80,000 5,000 3,500 71 500 71,500 96,000 5,000 3,500 87 500 87,500 22.38%

TheeffectonEBITisanamplified effectanditgoesinbothways. Wesaythatthereisoperating leveragewhentheeffectislarger than1:Whenthefirmhasfixedcosts, thereisoperatingleverage. Amnemonicdevicetohelpin remindingDOListhat,iffixedcosts are0,andthenDOLwillbeequalto 1. TohaveahighDOLdoesnotmeana goodfinancialhealth. health Ifthereis prosperity,tohavehighDOLisgood, BUTinarecessionitisbad. DOLisameasureofrisk.

FinancialLeverage
Financialleverageisthedegreetowhicha companyusesfixeditems,suchasdebtand preferredequity.Ahighdegreeoffinancial l leverage implies i li high hi hinterest i t tpayments. t As A a result,earningspersharearenegatively influencedbyinterestcharges.Thehigher interestpaymentsduetoincreasedfinancial leverage,thelowerEarningsperShare,EPS. Financialriskistherisktotheshareholders causedbyanincreaseindebtandpreferred equitiesinthefirmscapitalstructure.Whena firmincreasespreferredequitiesanddebt, interestchargesincrease,andEPSarereduced. Asaresult, result risktoshareholderreturnincreases. increases A firmshouldtakeintoaccountitsoptimalcapital structurewhenmakingfinancingdecisionsto makesureanyincreasesinpreferredequityand debtincreasethevalueofthefirm.

Apalancamiento Financiero
Sales Revenues -Variable costs and expenses CONTRIBUTION MARGIN - Fixed costs and expenses EBIT - Interest expenses Earnings before taxes EBT - Taxes Net Income

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DegreeofFinancialLeverage
ThisisthepercentagechangeinEPS dividedbythepercentagechangein EBIT.Thisisthe"degreeoffinancial leverage"(DFL). leverage (DFL) Itisameasureofthe sensitivityofEPStochangesinEBITas aresultofchangesindebt.Itcanbe seenasasortofelasticity. Amnemonicdevicetohelpin remindingDFListhat,ifinterestis0, DLFwillbeequalto1.
DFL = % EPS %EBIT = EBIT EBIT - interest charges

Degree offinancial leverage DFL

DFL =

EBT EBIT

EBIT EBT

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Example DegreeofFinancialLeverage
Afirmhasannualsalesof$8million. Thefirm'sgrossmarginis60%,andfixed costsare$3million. million Thefirm'sannual interestexpensesare$100,000.Ifwe increaseEBITby25%,howmuchwillthe company'sEPSincrease? Thecompany'sDFLiscalculatedas follows: DFL=($8$3.2$3)/(($8$2.2$3$0.1) DFL=$1.8/$1.7 $1 8/$1 7=1.059 1 059 IfEBITincreasesby20%,theDFL indicatesEPSwillincreaseto21.2% (20%1.059=21.2%)
FinancialandRatioAnalysis. Vlez

Example

Debt Interest Taxes Number of common shares

100,000 2% 40% 2,000

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DegreeofTotalLeverage DTL
EBIT Interests EBT Taxes Net Income EPS Impact on EPS DFL 55,500 71,500 2 000 2,000 2 000 2,000 87,500 2 000 2,000 85,500 34,200 51,300 25.65 23,02%

CombiningDOLwithDFLwe obtainthedegreeoftotal leverage(DTL).Ifacompanyhasa highDOLandDFL,asmallchange insaleswillleadtoalargechange inEPS.

53,500 69,500 21,400 27,800 32,100 41,700 16.05 -23,02% 1,03 20.85

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ApalancamientoTotal
Sales revenues - Variable costs and expenses CONTRIBUTION MARGIN - Fixed costs and expenses EBIT - Interest expenses EBT - Taxes Net Income

Degree ofTotalLeverage

DTL =

CM EBT

= DOL DFL

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Homework
CompaniesAandBhavethefollowingIncome Statements:
Sales Variable Costs Contribution Margin Fixed costs EBIT Interests EBT 4,000 2,000 2,000 1,000 1,000 $0 1,000 4,000 2,000 2,000 0 2,000 1,000 1.000

Iftaxesare30%andthenumberofsharesis 600.
Calculatethedifferentleveragesandexplain. Whichfirmisinbetterfinancialshape?