Professional Documents
Culture Documents
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
Business Risk
Business Risk
EBIT
FIRM
EPS
Stockholders
Business Risk
Affected by:
Sales volume variability
Competition
Product diversification
Operating leverage
Growth prospects
Size
Operating Leverage
EBIT
Operating
Leverage
Financial Risk
Financial Risk
FIRM
EPS
Stockholders
Financial Leverage
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
Total Revenue
$
profits
FC
losses
Breakeven
point
Q1
EBIT
Total Cost
= Fixed
Quantity
Total
Revenue
Trade-off:
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
sales
variable costs
fixed costs
operating income (EBIT)
interest
EBT
taxes
net income
Degree of Operating
Leverage (DOL)
DOLs =
% change in EBIT
% change in sales
DOLs =
% change in EBIT
% change in sales
change in EBIT
EBIT
change in sales
sales
Q(P - V)
Q(P - V) - F
Sales
EBIT
EPS
Stockholders
Degree of Financial
Leverage (DFL)
% change in EPS
% change in EBIT
% change in EPS
% change in EBIT
change in EPS
EPS
change in EBIT
EBIT
EBIT
DFL =
EBIT I P(1-t)
Sales
EBIT
EPS
Stockholders
Degree of Combined
Leverage (DCL)
change in EPS
EPS
change in Sales
Sales
DCL =
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
1,400,000 - 800,000
350,000
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
350,000
225,000
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
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
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.
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?