Dubai Women's College BADM300 Financial Management

Financial Management Fundamentals

Concepts of Operating and Financial Leverage

Leverage in business is derived from the word ‘lever’. A lever is a simple tool
by which a large weight can be moved with a small force.

The study of Leverage starts with our understanding of break-even or the

point at which a firm covers both fixed and variable costs.

OPERATING LEVERAGE

Operating leverage is a measure of the extent to which, fixed operating costs

are being used in an organization.

It is greatest (largest) in companies that have a high proportion of fixed

operating costs in relation (proportion) to variable operating costs. This type
of company is using more fixed assets in the operation of the company.

Conversely, operating leverage is lowest in companies that have a low

proportion of fixed operating costs in relation to variable operating costs.

Firms with large amounts of fixed operating costs have high break-even points
and high operating leverage. Variable cost in these firms tends to be low and
both the contribution (CM) and unit contribution (UC) margin is high.

Formula(s) for calculating Operating leverage :

Percent Change in Operating Income

Degree of Operating Leverage = Percent Change in Sales
or

Contributi on Margin
Degree of Operating Leverage = Earnings Before Interest and Taxes
or
Degree of Operating Leverage =

Total Sales −Total Variable Cost

Total Sales − Total Variable Cost − Total Operating Fixed Cost

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or

Degree of Operating Leverage =

Q ua w at Ohn ipt ci eth yr a t i n g

L e i cvs oe mr ax p g ( uPe t r e ui d−cVn e i a ct roP iu sae) nt br i ltp e e r
 Q ua w at Ohn ipt ci eth yr a t i n g 
 L e i Cvs e o r max (Pgp peru u ei t− cVnre eida t c rp oui e a)sn− r Obt i tl peF e Ci r x ao e tsd i t ns g
 

Example :

Company A and Company B are competitors in the market for a special machine
part. The cost structure and price details are given below:

Company A Company B
Selling price AED 30 AED 30
Variable cost per unit AED 10 AED 20
Fixed costs AED 60,000 AED 20,000

Question : Which firm has a high degree of operating leverage ?

Answer :

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C-V-P analysis of Company A and Company B

Company A
Units sold Variable costs Fixed costs Total costs Revenue Operating
Income (loss)
0
2,000
3,000
4,000
5,000

Company B
Units sold Variable costs Fixed costs Total costs Revenue Operating
Income (loss)
0
2,000
3,000
4,000
5,000

Calculations of “Degree of Operating Leverage”:

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Implications:

1. A firm with a high break-even point is more risky than one with a low
Break-even point. In periods of increasing sales, operating income (OI or
EBIT) of the leveraged firm tends to increase rapidly. This increase in
OI (EBIT) is the ‘pay-off’ for being more risky. But in periods of
decreasing sales, operating income of the firm tends to decrease
rapidly, that is the risk.

2. Firms with small amounts of fixed operating costs have low break-even
points and are therefore less risky and have low operating leverage.
Variable costs in these firms tend to be high and both the CM and UC is
low. In periods of increasing sales, Operating income (EBIT) for these
firms tends to increase slowly. But in periods of decreasing sales,
Operating income will tend to decrease slowly making the firm less risky.

3. In conclusion, if a company has high operating leverage, then the

operating income (OI or EBIT) will become very sensitive to changes in
sales volume. Just a small percentage (%) chance in sales can yield
(produce) a large percentage change in Operating Income. A Company
with low operating leverage the reverse is true.

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FINANCIAL LEVERAGE

Financial leverage is the extent to which debt (liability) is used in the Capital
Structure (financing) of the firm. Capital Structure refers to the relationship
between assets, debt (liability) and equity. The more debt a firm has relative
to equity the greater the financial leverage (these firms have a higher Debt to
Asset ratios).

Example :

Let us say both companies have the following capital structure:

Company A Company B
Debt (10%) 100,000 Debt (10%) 40,000
Sh. Equity (AED 10 par) 40,000 Sh. Equity (AED 10 par) 100,000
(4,000 shares) --------- (10,000 shares) ----------
Total Capital 140,000 Total Capital 140,000

Substantial use of debt will place a great burden on the firm at low levels of
profitability (low EBIT, since interest must be paid). However, it will also help
to magnify (enlarge) increases in earning per share (EPS) as the EBIT or
operating income increases.

Percent Change in Earnings Per Share

Degree of Financial Leverage = Percent Change in Operating Income
or

Earnings Before Interest and Taxes

Degree of Financial Leverage = Earnings Before Interest and Taxes − Interest

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Calculations of Income statements at different levels of operations:

Company A AED Company B AED
Sales (4,000 units) Sales (4,000 units)
Less: Var. costs Less: Var. costs
Fix.costs Fix.costs
EBIT EBIT
Less : Interest Less : Interest
EBT EBT
Less: Tax (50%) Less: Tax (50%)
EAT EAT

EPS EPS

Sales (5,000 units) Sales (5,000 units)

Less: Var. costs Less: Var. costs
Fixed costs Fixed costs
EBIT EBIT
Less : Interest Less : Interest
EBT EBT
Less: Tax (50%) Less: Tax (50%)
EAT EAT

EPS EPS

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Implications
1. Financial leverage can be very useful to a firm if properly used under the
right conditions. For firms in industries that have a degree of stability
and/or show growth, the use of debt is recommended because of the
positive aspects of financial leverage.

BUT...

2. As a firm increases the use of debt in its capital structure, creditors

(lenders) will perceive a greater financial risk in lending money to the
firm and therefore may charge a higher interest rate which may lower
earning before tax (EBT). These lenders will perhaps place other
restrictions on the firm. Stockholders may become concerned with the
risk to EPS and sell the stock (which will force the market price down).

3. In conclusion, Financial leverage is a very useful tool if used correctly

and under the right conditions. At times, the value of the firm is
enhanced by financial leverage.

COMBINED LEVERAGE
When financial leverage is combined with operating leverage the effect of a
change in output (sales) in magnified in the change in earning per share (EPS).
Operating leverage gives us the change in EBIT with a change in sales and
financial leverage gives us the change in EPS with a change in EBIT. We cam
then see the change in EPS for a change in sales (volume of output). The
combining both concepts as can be seen below:

Operating Leverage is:

Change in sales leads to a change in EBIT

Financial Leverage is:

Change in EBIT leads to a change in EPS

Therefore, Combined Leverage is:

Change in sales leads to a change in EPS.

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Now, we can determine the effect of a change in output (sales) on earnings per
share (EPS). In this way, we can better depict the relative influence of the
two types of leverage for the firm. We can determine and examine the effect
of adding financial leverage on top of operating leverage.

Percent Change in Earnings Per Share

Degree of Combined Leverage = Percent Change in Sales (or volume )

or

Degree of Combined Leverage = Degree of Operating x Degree of Financial

Leverage Leverage

or

Degree of Combined Leverage=

Q auw t aO h n pi tc ei ht r y a t i n g
L ei c sv o e mr a p x g u e t ( ep Pdr u i −eVnc r eiac t por u eis) na rt ib t l e
 Q auw t aO h n pi tc ei ht r y a t i n g 
 L ei C sv eo rxm(Pa pgr ui e − c utV e n adc i prot )i eus− aO rtn b piF lpt Cee i e −xrI or ane s dt t ie sn r ge s t
 
Calculate the degree of combined leverage for both firms:

Implication:

1. Remember that a firm with high leverage(s) will have large increases in

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EPS for changes in sales but will also have large decreases in EPS for
decreases in sales (and therefore have high risk).

2. Firms that have lower leverage(s), with have smaller increases in EPS for
the same change in sales and will have smaller decreases in EPS for the
same decrease in sales (and therefore have lower risk).

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