Analysis and Impact of Leverage?

SALES Income Statement - Cost of Goods Sold GROSS PROFIT - Operating Expenses OPERATING INCOME (EBIT) - Interest Expense EARNINGS BEFORE TAXES (EBT) - Income Taxes EARNINGS AFTER TAXES (EAT) - Preferred Stock Dividends - NET INCOME AVAILABLE TO COMMON STOCKHOLDERS

SALES Income Statement - Cost of Goods Sold GROSS PROFIT - Operating Expenses OPERATING INCOME (EBIT) - Interest Expense EARNINGS BEFORE TAXES (EBT) - Income Taxes EARNINGS AFTER TAXES (EAT) - Preferred Stock Dividends - NET INCOME AVAILABLE TO COMMON STOCKHOLDERS

Two concepts that enhance our understanding of risk... 1) Operating Leverage - affects a firms business risk. risk. 2) Financial Leverage - affects a firms financial risk. risk.

Business Risk

 The variability or uncertainty of a

firms operating income (EBIT).

EBIT

FIRM

EPS

StockStockholders

Business Risk
Affected by:  Sales volume variability  Competition  Product diversification  Operating leverage  Growth prospects  Size

Operating Leverage
 The use of fixed operating costs as
costs. opposed to variable operating costs.  A firm with relatively high fixed operating costs will experience more variable operating income if sales change.

EBIT
Operating Leverage

Financial Risk

 The variability or uncertainty of

a firms earnings per share (EPS) and the increased probability of insolvency that arises when a leverage. firm uses financial leverage. EBIT FIRM EPS StockStockholders

Financial Leverage
fixed The use of fixed-cost sources of financing (debt, preferred stock) variablerather than variable-cost sources (common stock).
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.

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 Total Cost

FC

{
Quantity

Total Revenue

} EBIT

Total Cost

FC {
Break-even point

Q1

Quantity

Total Revenue

If the firm increases its fixed operating costs and reduces (or eliminates) its variable costs

+
FC

}
Q1

EBIT
Total Cost = Fixed
Qty

Break-even point
Operating Leverage

With high operating leverage, leverage, an increase in sales produces a relatively larger increase in operating income. income.

TradeTrade-off: the firm has a higher breakeven point. If sales are not high enough, the firm will not meet its fixed expenses!

Total Revenue

+
FC

}
Q1

EBIT
Total Cost = Fixed Qty

Breakeven point

Breakeven Calculations
Breakeven point (units of output) (units 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) (sales dollars)

S* =

F VC 1S

 S* = breakeven level of sales.  F = total anticipated fixed costs.  S = total sales.  VC = total variable costs.

Analytical Income Statement

sales variable costs fixed costs operating income interest EBT taxes net income

Degree of Operating Leverage (DOL)

 Operating leverage: by using fixed leverage:

operating costs, a small change in sales revenue is magnified into a larger change in operating income. income.

 This multiplier effect is called

leverage. the degree of operating leverage.

Degree of Operating Leverage

from Sales Level (S)

DOLs =

% change in EBIT % change in sales change in EBIT EBIT change in sales sales

Degree of Operating Leverage

from Sales Level (S)

 If we have the data, we can use this formula:

Sales - Variable Costs DOLs = EBIT = Q(P - V) Q(P - V) - F

What does this tell us?

 If DOL = 2, then a 1% increase in
sales will result in a 2% increase in operating income (EBIT).

Sales

EBIT

EPS

Stockholders

Degree of Financial Leverage (DFL)

 Financial leverage: by using fixed leverage:

cost financing, a small change in operating income is magnified into a larger change in earnings per share. share.

 This multiplier effect is called

the degree of financial leverage. leverage.

Degree of Financial Leverage

DFL = % change in EPS % change in EBIT change in EPS EPS change in EBIT EBIT

Degree of Financial Leverage

 If we have the data, we can use this
formula:

EBIT DFL = EBIT - I

What does this tell us?

 If DFL = 3, then a 1% increase in 3,
operating income will result in a 3% increase in earnings per share.

Sales

EBIT

EPS

Stockholders

Degree of Combined Leverage (DCL)

 Combined leverage: by using operating leverage:

leverage and financial leverage, a small leverage, change in sales is magnified into a larger change in earnings per share. share.

 This multiplier effect is called the

degree of combined leverage. leverage.

Degree of Combined Leverage

DCL = DOL x DFL % change in EPS = % change in Sales change in EPS EPS change in Sales Sales

Degree of Combined Leverage

 If we have the data, we can use this
formula:

DCL =

Sales - Variable Costs EBIT - I Q(P - V) Q(P - V) - F - I

What does this tell us?

 If DCL = 4, then a 1% increase in
sales will result in a 4% increase in earnings per share.

Sales

EBIT

EPS

Stockholders

In-class Project: InBased on the following information on Levered Company, answer these questions: 1) If sales increase by 10%, what should 10%, happen to operating income? income? 10%, 2) If operating income increases by 10%, what should happen to EPS? EPS? 3) If sales increase by 10%, what should be 10%, EPS? 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

EPS

Operating leverage

Financial leverage

Degree of Operating Leverage

from Sales Level (S)

Sales - Variable Costs DOLs = EBIT = 1,400,000 - 800,000 350,000 = 1.714

Levered Company

Sales

Operating Income

EPS

Levered Company
17.14%

10%

Sales

Operating Income

EPS

Operating leverage

Degree of Financial Leverage

EBIT DFL = EBIT - I = 350,000 225,000 = 1.556

Levered Company
10%
15.56%

Sales

Operating Income

EPS

Financial leverage

Degree of Combined Leverage

Sales - Variable Costs EBIT - I 1,400,000 - 800,000 225,000 2.667

DCL

Levered Company
10%
26.67%

Sales

Operating Income

EPS

Operating leverage

Financial leverage

Levered Company
10% increase in sales

Sales (110,000 units) (110, Variable Costs Fixed Costs EBIT Interest EBT Taxes (34%) (34%) Net Income EPS

1,540,000 540, (880,000) 880,000) (250,000) 250,000) 410, 410,000 ( +17.14%) +17.14%) (125,000) 125,000) 285,000 285, (96,900) 96,900) 188,100 188, $1.881 ( +26.67%) +26.67%)