OPERATING AND

FINANCIAL
LEVERAGE
Prof. Maricel R. Dizon, CPA, MPA, DipPM
September 18, 2021
 Introduction
▪ In financing and investment decisions there are
may types of risk we must consider. These include:

▫ Cash Flow Risk

▫ Reinvestment Risk
▫ Interest Rate Risk
▫ Purchasing Power Risk
▫ Currency Risk
▫ Portfolio Risk
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 Introduction
▪ Cash flow risk is the risk that the cash flows of an investment
will not materialize as expected.

▫ Business Risk is the risk associated with the operating

cash flows. Operating cash flows are not certain because
of the revenues nor the expenditures comprising the cash
flows uncertainty (Sales and Operating Risks)

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Introduction

▫ Sales Risk – Prices or quantity of sales (or both) may

be different from what is expected.
▫ Operating Risk – Risk that comes from the mix of
fixed and variable costs. The greater the fixed
operating costs relative to variable operating costs,
the greater the operating risk.

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How operating risk affects the cash flow risk?

• Sensitivity of firm’s operating cash flows to changes in

demand, as measured by units sales
• Degree of Operating Leverage is the ratio of the %
change in operating cash flows to the % change in units
sold.

• Leverage is that the portion of the fixed costs w/c

represents a risk to the firm
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Leverage
• Operating leverage a measure of operating risk, refers to the
fixed operating costs found in the firm’s income statement
• Financial leverage a measure of financial risk, refers to
financing a portion of the firm’s assets, bearing fixed financing
charges in hopes of increasing the return to the common
stockholders.
• The higher the financial leverage, the higher the financial risk, and
the higher the cost of capital. Cost of capital rises because it costs
more to raise funds for a risky business
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Break-Even Analysis
• A discussion of break-even analysis, broadly known as cost/
volume/profit analysis, is necessary for understanding the
nature and importance of operating leverage:

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Break-Even Analysis
• The break-even point is the level of sales at which no profit or
loss results.

• To determine the breakeven point, the costs must be divided into

(1) variable costs, which are costs that vary in direct proportion to
a change in volume, and (2) fixed costs, which are costs that are
constant regardless of volume.

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Break-Even Analysis
• The break-even point can be found easily by setting sales just
equal to the total of the variable costs plus the fixed costs:
Let: Then:
S=Sales S = VC + FC
X=Sales volume in units PX = VX + FC
P=Selling Price Per unit (P-V)X = FC
V=Unit Variable Cost FC
X =
VC=Variable Operating Costs P-V
FC=Fixed Operating Costs
Or
Fixed operating costs
Break-even sales in units = unit selling price - unit variable cost

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Break-Even Analysis: Example
• Jawhead Company manufactures and sells doors to home
builders. The doors are sold for P25 each. Variable costs are P15
per door, and fixed operating costs total P50,000. The company’s
break-even point is:

• Recitation:

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Break-Even Analysis: Example
• Jawhead Company manufactures and sells doors to home
builders. The doors are sold for P25 each. Variable costs are P15
per door, and fixed operating costs total P50,000. The company’s
break-even point is:

• Recitation:
FC P50,000.00
X= = = 5,000 doors
P-V P25.00-P15.00

Therefore, the company must sell 5,000 doors to break even

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Cash Break Even Point

• If a firm has a minimum of available cash or the opportunity cost

of holding excess cash is high, management may want to know
the volume of sales that will cover all cash expenses during a
period. This is known as the cash break-even point.

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Cash Break Even Point

• Not all fixed operating costs involve cash payments. For example,
depreciation expenses are non-cash charges. To find the cash
break-even point, the non-cash charges must be subtracted from
total fixed operating costs. Therefore, the cash break-even point
is lower than the usual break-even point. The formula is:

FC- d
X=
P-V
Where d is depreciation expense

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Cash Break Even Point: Example

• Assume the same example: Jawhead Company manufactures and

sells doors to home builders. The doors are sold for P25 each.
Variable costs are P15 per door, and fixed operating costs total
P50,000 include depreciation in the amount of P2,000.00. Then
the cash break-even point is:

• Recitation:

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Cash Break Even Point: Example

• Assume the same example: Jawhead Company manufactures and

sells doors to home builders. The doors are sold for P25 each.
Variable costs are P15 per door, and fixed operating costs total
P50,000 include depreciation in the amount of P2,000.00. Then
the cash break-even point is:
FC- d P50,000.00 - P2,000.00
X= = = 4,800 doors
P-V P25.00 - P15.00

The company has to sell 4,800 doors to cover only the fixed costs
involving cash payments of P48,000.00 and to break even.

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Operating Leverage
• Operating leverage is a measure of operating risk and arises
from fixed operating costs. A simple indication of operating
leverage is the effect that a change in sales has on earnings.
The formula is:
Operating leverage at a given % change in EBIT (P-V)X
= =
level of sales (x) % change in sales (P-V)X - FC

Where:
EBIT = earnings before interest and taxes
= (P-V)X - FC
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Operating Leverage: Example
• Assume that Jawhead Company is currently selling 6,000 doors
per year. Its operating leverage is:

• Recitation:

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Operating Leverage: Example
• Assume that Jawhead Company is currently selling 6,000 doors
per year. Its operating leverage is:

(P - V) X (P25.00-P15.00)(6,000) P60,000.00
= = = 6
(P - V) X - FC [(P25.00 - P15.00)(6000)] - P50,000.00 P10,000.00

Which means is sales increase by 10%, the company can expect its net income to
increase by six times that amount, or 60%

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Financial Leverage
• Financial leverage is a measure of financial risk and arises
from fixed financial costs. One way to measure financial
leverage is to determine how earnings per share are affected
by a change in EBIT (or operating income).
Formula:
Financial leverage at a given % change in EPS (P - V)X - FC
= =
level of sales (X) % change in EBIT (P - V)X - FC - IC

where EPS is earnings per share, and IC is fixed finance charges, i.e., interest
expense or preferred stock dividends. [Preferred stock divident must be
adjusted for taxes, i.e., preferred stock dividend/(1 - t ).]

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Financial Leverage: Example
• The Jawhead Company has total financial charges of P2,000,
half in interest expense and half in preferred stock dividend.
The corporate tax rate is 40 percent. What is their financial
leverage?

Recitation:

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Financial Leverage: Example
• The Jawhead Company has total financial charges of P2,000,
half in interest expense and half in preferred stock dividend.
The corporate tax rate is 40 percent. What is their financial
leverage?
First:
P1,000.00
IC = P1,000.00 + = P1,000.00 + P1,667.00 = P2,667.00
(1 - 0.4)

Therefore, Jawhead's financial leverage is computed as follows:

(P - V)X - FC (P25.00 - P15.00)(6,000) - P50,000.00 P10,000.00

= = = 1.36
(P - V)X - FC - IC (P25.00 - P15.00)(6,000) - P50,000.00 - P2,667.00 P7,333.00

Which means that if EBIT increases by 10%, Jawhead can expect its EPS to increase by 1.36 times, or by
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13.6%.
Total Leverage
• Total leverage is a measure of total risk. The way to measure
total leverage is to determine how EPS is affected by a change
in sales:
Total leverage at a % change in EPS
=
given level of sales (X) % change in sales

= Operating leverage x financial leverage

(P - V)X (P-V)X - FC
= x
(P - V)X - FC (P-V)X - FC - IC
(P - V)X
=
(P - V)X - FC - IC 22
Total Leverage: Example
• The total leverage of Jawhead Company is:

• Recitation:

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Total Leverage: Example
• The total leverage of Jawhead Company is:

(P - V)X (P25.00 - P15.00)(6,000)

=
(P - V)X - FC - IC (P25.00 - P15.00)(6,000) - P50,000.00 - P2,667.00

P60,000.00 8.18
= =
P7,333.00 (as rounded)

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How operating risk affects the cash flow risk?
• Degree of Operating Leverage is the ratio of the %
change in operating cash flows to the % change in units
sold.

% Change in operating cash flows

DOL =
% Change in units sold

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Example:
• Suppose the price per unit is P30.00, the variable cost per unit is
P20.00, and the total fixed costs are P5,000.00. If we go from selling
1,000 units to selling 1,500 units, an increase of 50% of the units sold,
operating cash flows change from:

Particulars 1000 units sold 1500 units sold

Sales 30,000.00 45,000.00
Less variable cost 20,000.00 30,000.00
Less fixed costs 5,000.00 5,000.00
Operating cash flow 5,000.00 10,000.00

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Example:
• Operating cash flows doubled when units sold increased by 50%. What
if the number of units decreases by 25%, from 1,000 to 750?
Recitation:

Particulars 1500 units sold 1000 units sold 750 units sold
Sales 45,000.00 30,000.00 22,500.00
Less variable cost 30,000.00 20,000.00 15,000.00
Less fixed costs 5,000.00 5,000.00 5,000.00
Operating cash flow 10,000.00 5,000.00

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Example:
• Operating cash flows doubled when units sold increased by 50%. What
if the number of units decreases by 25%, from 1,000 to 750?
Particulars 1500 units sold 1000 units sold 750 units sold
Sales 45,000.00 30,000.00 22,500.00
Less variable cost 30,000.00 20,000.00 15,000.00
Less fixed costs 5,000.00 5,000.00 5,000.00
Operating cash flow 10,000.00 5,000.00 2,500.00

• Operating cash flows decline by 50%. For any 1% change in units sold, the operating cash flow
changes by 2%, in the same direction. So if units sold increased by 10%, operating cash flows
would increase by 20%; if units sold decreased by 10%, operating cash flows would decrease
by 20%.

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