Reading 34: Measures of Leverage
General concepts
Leverage increases the risk and potential return of a firm's earnings and cash flow.
Leverage: effect of fixed elements in cost structure
Sales risk is uncertainty about firm's sales
Business risk: is variability in Operating earnings (EBIT); result from the variability in sales and expenses. Is magnified by Operating Leverage.
Financial Risk: is the additional variability of EPS compared to EBIT; increases with greater use of fixed interest cost financing in the company's capital structure.
Leverage degrees
Degree of Operating leverage (DOL) = %ΔEBIT%ΔSales=Q×(P−V)Q×(P−V)−F
Degree of Financial Leverage (DFL) = \(\frac{EBIT}{EBIT-I}= \frac{\%\Delta EPS}{\%\Delta EBIT}\)
Degree of Total Leverage (DTL) = DOL x DFL = \(\frac{\%\Delta EPS}{\%\Delta Sales}\)
Breakeven quantity of sales
Breakeven quantity of sales : is the amount of sales that makes Net Income = 0
Net Income at various sale levels = Total revenue - Total Cost = Price x Quantity - Total Fixed Cost - Variable Cost Per Unit x Quantity
Operating Breakeven Quantity of Sale
Operating Breakeven Quantity of Sale is the sale quantity that make operating income = 0 (produce just to cover operating cost)
Operating leverage: fixed operating expenses
Financial leverage: Fixed financing costs
Terminology
Q: Quantity sold
P: Price sold
V: Variable cost
F: Fixed cost
Interpretation:1% change in sale will cause EBIT to change (1xA)%
I: Interest
Interpretation: 1% change in EBIT will cause EPS to change (1xA)%
Interpretation: 1% change in Sale will cause EPS to change (1xA)%
Firms characteristics and leverage
3 rules of leverage
- High fixed costs = high operating leverage
- High debt ratio = high financial leverage
- High fixed cost + high debt ratio = high total leverage
Breakeven Quantity = \(\frac{FixedTotalCost}{Price-VariableCostPerUnit}=\frac{FixedOperatingCost+ FixedFinancingCost}{Price-VariableCostPerUnit}\)
Operating Breakeven Quantity of Sale= \(\frac{FixedOperatingCost}{P-VariableCostPerUnit}\)
Effects of financial leverage on Net Income and ROE
Net effect can be either increase or decrease in ROE
More debt & less equity --> both less net income (as interest expense rises) and net equity
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