Module 9

Financial Leverage
LEARNING OBJECTIVES
After studying Module 9, you should be able to:
1. Understand the concept and application of leverage in business.
2. Explain the meaning of operating leverage.
3. Understand the nature of financial leverage.
Operating and Financial Leverage
Introduction
Leverage represents the use of fixed costs items to magnify the firm's results. It is however,
important to keep in mind that leverage is a two-edged sword producing highly favorable results
when things go well, and quite the opposite under negative conditions.
Leverage in a Business
Assume that there exists an opportunity to start your own business. You are to manufacture and
market industrial parts, such as ball bearings, wheels and casters. You are faced with two primary
decisions.
First, you must determine the amount of fixed cost plant and equipment you wish to use in the
production process. By installing modern, sophisticated equipment, you can virtually eliminate
labor in the production of inventory. At high volume, you will do quite well, as most of your costs
are fixed payments for plant and equipment. If you decide to use expensive labor rather than
machinery, you will lessen your opportunity for profit, but at the same time, you will lower your
exposure to risk (you can lay off part of the workforce).
Second, you must determine how you will finance the business. If you rely on debt financing and
the business is successful, you will generate substantial profits as an owner, paying only the fixed
costs of debt. Of course, if the business starts off poorly, the contractual obligations related to debt
could mean bankruptcy. As an alternative, you might decide to sell equity rather than borrow a
step that will lower your own profit potential but minimize your risk exposure.
In both decisions, you are making very explicit decisions about the use of leverage. To the extent
that you go with a heavy commitment to fixed costs in the operation of the firm, you are employing
operating leverage. To the extent that you utilize debt in the financing of the firm, you are engaging
in financial leverage. We shall carefully examine each type of leverage and then show the
combined effect of both.
Operating Leverage
Operating leverage is a measure of how sensitive net operating income is to a given percentage
change in peso sales. Operating leverage acts as a multiplier. If operating leverage is high, a small
percentage increase in sales can produce a much larger percentage increase in net operating
income. Operating leverage can be illustrated with use of the following data for two mango farms,
Green Farm and Yellow Farm.

Degree of Operating Leverage

The degree of operating leverage at a given level of sales is computed by the following formula:

Degree of operating leverage = Contribution Margin

Net Operating Income
The degree of operating leverage is a measure, at a given level of sales, of how a percentage change
in sales volume will affect profits. To illustrate, the degree of operating leverage for the two farms
at Php. 100,000.00 sales would be computed as follows.

Green Farm 40,000.00 =4

10,000.00
Yellow Farm 70,000.00 =7
10,000.00
Because the degree of operating leverage for Green Farm is 4, the farm's net operating income
grows four times as fast as its sales. In contrast, Yellow Farm's net operating income grows seven
times as fast as its sales. Thus, if sales increase by 10%, then we can expect the net operating
income of Green Farm to increase by four times this amount, or by 40% and the net operating
income of Yellow Farm to increase by seven times this amount or by 70%.
Percent Increase in Degree of Operating Percent Increase in
Sales Leverage Net Operating Income
(1) (2) (1) x (2)
Green Farm 10% 4 40 %
Yellow Farm 10% 7 70 %

Financial Leverage
Having discussed the effect of fixed costs on the operations of the firm (operating leverage), we
now turn to the second form of leverage. Financial leverage reflects the amount of debt used in the
capital structure of the firm. Because debt carries a fixed obligation of interest payments, we have
the opportunity to greatly magnify our results at various levels of operations. You may have heard
of the real estate developer who borrows 100 percent of the costs of his project and will enjoy an
infinite return on his zero investment if all goes well.
It is helpful to think of operating leverage as primarily affecting the left-hand side of the statement
of financial position and financial leverage as affecting the right-hand side.
Statement of Financial Position
Assets Liabilities and Owners’ Equity
Operating Leverage Financial Leverage

Whereas operating leverage influences the mix of plant and equipment, financial leverage
determines how the operation is to be financed. It is possible for two firms to have equal operating
capabilities and yet show widely different results because of the use of financial leverage.
Impact on Earnings
In studying the impact of financial leverage, we shall examine two financial plans for a firm, each
employing a significantly different amount of debt in the capital structure. Financing totaling
P200,000.00 is required to carry the assets of the firm.
Under leveraged Plan A, we will borrow PI50,000 and sell 8,000 shares of stock at P6.25 to raise
an additional P50,000, whereas conservative Plan B calls for borrowing only P50,000 and
acquiring an additional P150,000 in stock with 24,000 shares.