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Financial Management

Financial Management Fundamentals Concepts of Operating and Financial Leverage Leverage in business is derived from the word lever. A lever is a simple tool by which a large weight can be moved with a small force. The study of Leverage starts with our understanding of break-even or the point at which a firm covers both fixed and variable costs. OPERATING LEVERAGE Operating leverage is a measure of the extent to which, fixed operating costs are being used in an organization. It is greatest (largest) in companies that have a high proportion of fixed operating costs in relation (proportion) to variable operating costs. This type of company is using more fixed assets in the operation of the company. Conversely, operating leverage is lowest in companies that have a low proportion of fixed operating costs in relation to variable operating costs. Firms with large amounts of fixed operating costs have high break-even points and high operating leverage. Variable cost in these firms tends to be low and both the contribution (CM) and unit contribution (UC) margin is high. Formula(s) for calculating Operating leverage :

Degree of Operating Leverage = or

Percent Change in Operating Income Percent Change in Sales

Degree of Operating Leverage = Earnings Before Interest and Taxes or Degree of Operating Leverage =
Total Sales Total Variable Cost Total Sales Total Variable Cost Total Operating Fixed Cost

Contributi on Margin

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Financial Management

or Degree of Operating Leverage =

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Example : Company A and Company B are competitors in the market for a special machine part. The cost structure and price details are given below: Company A AED 30 AED 10 AED 60,000 Company B AED 30 AED 20 AED 20,000

Selling price Variable cost per unit Fixed costs

Question : Which firm has a high degree of operating leverage ? Answer :

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Dubai Women's College

BADM300

Financial Management

C-V-P analysis of Company A and Company B Company A

Units sold Variable costs Fixed costs Total costs Revenue Operating Income (loss)

0 2,000 3,000 4,000 5,000

Company B
Units sold Variable costs Fixed costs Total costs Revenue Operating Income (loss)

0 2,000 3,000 4,000 5,000

Calculations of Degree of Operating Leverage:

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BADM300

Financial Management

Implications: 1. A firm with a high break-even point is more risky than one with a low Break-even point. In periods of increasing sales, operating income (OI or EBIT) of the leveraged firm tends to increase rapidly. This increase in OI (EBIT) is the pay-off for being more risky. But in periods of decreasing sales, operating income of the firm tends to decrease rapidly, that is the risk. Firms with small amounts of fixed operating costs have low break-even points and are therefore less risky and have low operating leverage. Variable costs in these firms tend to be high and both the CM and UC is low. In periods of increasing sales, Operating income (EBIT) for these firms tends to increase slowly. But in periods of decreasing sales, Operating income will tend to decrease slowly making the firm less risky. In conclusion, if a company has high operating leverage, then the operating income (OI or EBIT) will become very sensitive to changes in sales volume. Just a small percentage (%) chance in sales can yield (produce) a large percentage change in Operating Income. A Company with low operating leverage the reverse is true.

2.

3.

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Financial Management

FINANCIAL LEVERAGE Financial leverage is the extent to which debt (liability) is used in the Capital Structure (financing) of the firm. Capital Structure refers to the relationship between assets, debt (liability) and equity. The more debt a firm has relative to equity the greater the financial leverage (these firms have a higher Debt to Asset ratios). Example : Let us say both companies have the following capital structure: Company A Company B

Debt (10%) 100,000 Sh. Equity (AED 10 par) 40,000 (4,000 shares) --------Total Capital 140,000

Debt (10%) 40,000 Sh. Equity (AED 10 par) 100,000 (10,000 shares) ---------Total Capital 140,000

Substantial use of debt will place a great burden on the firm at low levels of profitability (low EBIT, since interest must be paid). However, it will also help to magnify (enlarge) increases in earning per share (EPS) as the EBIT or operating income increases. Degree of Financial Leverage = or Degree of Financial Leverage = Earnings Before Interest and Taxes Interest
Earnings Before Interest and Taxes

Percent Change in Earnings Per Share Percent Change in Operating Income

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Financial Management

Calculations of Income statements at different levels of operations: Company A AED Company B AED
Sales (4,000 units) Less: Var. costs Fix.costs EBIT Less : Interest EBT Less: Tax (50%) EAT EPS Sales (4,000 units) Less: Var. costs Fix.costs EBIT Less : Interest EBT Less: Tax (50%) EAT EPS

Sales (5,000 units) Less: Var. costs Fixed costs EBIT Less : Interest EBT Less: Tax (50%) EAT EPS

Sales (5,000 units) Less: Var. costs Fixed costs EBIT Less : Interest EBT Less: Tax (50%) EAT EPS

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BADM300

Financial Management

Implications 1. Financial leverage can be very useful to a firm if properly used under the right conditions. For firms in industries that have a degree of stability and/or show growth, the use of debt is recommended because of the positive aspects of financial leverage. BUT... 2. As a firm increases the use of debt in its capital structure, creditors (lenders) will perceive a greater financial risk in lending money to the firm and therefore may charge a higher interest rate which may lower earning before tax (EBT). These lenders will perhaps place other restrictions on the firm. Stockholders may become concerned with the risk to EPS and sell the stock (which will force the market price down). In conclusion, Financial leverage is a very useful tool if used correctly and under the right conditions. At times, the value of the firm is enhanced by financial leverage.

3.

COMBINED LEVERAGE When financial leverage is combined with operating leverage the effect of a change in output (sales) in magnified in the change in earning per share (EPS). Operating leverage gives us the change in EBIT with a change in sales and financial leverage gives us the change in EPS with a change in EBIT. We cam then see the change in EPS for a change in sales (volume of output). The combining both concepts as can be seen below: Operating Leverage is: Change in sales leads to a change in EBIT Financial Leverage is: Change in EBIT leads to a change in EPS Therefore, Combined Leverage is: Change in sales leads to a change in EPS.

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Financial Management

Now, we can determine the effect of a change in output (sales) on earnings per share (EPS). In this way, we can better depict the relative influence of the two types of leverage for the firm. We can determine and examine the effect of adding financial leverage on top of operating leverage. Degree of Combined Leverage = or Degree of Combined Leverage = Degree of Operating x Degree of Financial Leverage Leverage or Degree of Combined Leverage=
Percent Change in Earnings Per Share Percent Change in Sales (or volume )

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Calculate the degree of combined leverage for both firms:

Implication: 1. Remember that a firm with high leverage(s) will have large increases in

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EPS for changes in sales but will also have large decreases in EPS for decreases in sales (and therefore have high risk). 2. Firms that have lower leverage(s), with have smaller increases in EPS for the same change in sales and will have smaller decreases in EPS for the same decrease in sales (and therefore have lower risk).

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