Operating and Financial

Leverage
 What is Leverage?
Break-Even (BE) Point
Operating Leverage
Financial Leverage
Leverage Means Risk
Combined or Total Leverage
What is Leverage?
Use of special forces and effects to magnify or produce more
than the normal results from a given course of action

Leverage involves using fixed costs to magnify the

potential return to a firm

Can produce beneficial results in favorable conditions

Can produce highly negative results in unfavorable conditions
 Leverage in a Business
Determining type of fixed operational costs
Plant and equipment
Can reduce expensive labor in production of inventory
Expensive labor
Lessens opportunity for profit but reduces risk exposure
Determining type of fixed financial costs
Debt financing
Can produce substantial profits, but failure to meet contractual obligations can
result in bankruptcy
Selling equity
May reduce potential profits for existing shareholders, but reduces their risk
exposure
Break-Even (BE) Point
Quantity where Total Revenue equals Total Cost
Company has no Profit or Loss
BE = FC / (P VC)
A leveraged firm has a high BE point
A non-leveraged firm has a low BE point
FIGURE
Break-even chart:
Leveraged firm
FIGURE
Break-even chart:
Conservative firm
TABLE
Volume-cost-profit analysis:
Leveraged firm
TABLE
Volume-cost-profit analysis:
Conservative firm
FIGURE
Nonlinear break-even
analysis
Operating Leverage

Measure of the amount of fixed operating costs used by

a firm.
Degree of Operating Leverage (DOL) = % in EBIT
(or Operating Income) / % in Sales

DOL = Q(P-VC) / (Q(P-VC) FC)

Operating Leverage measures the sensitivity of a firms

operating income to a in sales.
TABLE
Operating income or
loss
Financial Leverage

Measure of the amount of debt used by a firm

Degree of Financial Leverage (DFL) = % in EPS /
% in EBIT (or Operating Income)

DFL = EBIT / (EBIT I)

Financial Leverage measures the sensitivity of a firms

earnings per share to a in operating income
FIGURE
Financing plans and
earnings per share
TABLE
Impact of financing
plan on earnings
per share
Financial Leverage
Reflects the amount of debt used in the capital structure of
the firm
Determines how the operation is to be financed
Determines the performance between two firms having equal
operating capabilities

BALANCE SHEET
Assets Liabilities and Net Worth
Operating leverage Financial leverage
TABLE
Income statement
TABLE
Operating and
financial leverage
Combining Operating
and Financial Leverage
Combined leverage: when both leverages allow a firm to
maximize returns
Operating leverage:
Affects the asset structure of the firm
Determines the return from operations
Financial leverage:
Affects the debt-equity mix
Determines how the benefits received will be allocated