Chapter 5

Operating and Financial

Leverage
Chapter 5 - Outline

 What is Leverage?
 Break-Even (BE) Point
 Operating Leverage
 Financial Leverage
 Leverage Means Risk
 Combined or Total Leverage
What is Leverage?
 Use of special forces and effects to magnify or produce more
than the normal results from a given course of action

 Leverage involves using fixed costs to magnify the

potential return to a firm

 Can produce beneficial results in favorable conditions

 Can produce highly negative results in unfavorable conditions
 Leverage in a Business
 Determining type of fixed operational costs
 Plant and equipment
 Can reduce expensive labor in production of inventory
 Expensive labor
 Lessens opportunity for profit but reduces risk exposure
 Determining type of fixed financial costs
 Debt financing
 Can produce substantial profits, but failure to meet contractual obligations can
result in bankruptcy
 Selling equity
 May reduce potential profits for existing shareholders, but reduces their risk
exposure
Break-Even (BE) Point
 Quantity where Total Revenue equals Total Cost
 Company has no Profit or Loss
 BE = FC / (P –VC)
 A leveraged firm has a high BE point
 A non-leveraged firm has a low BE point
FIGURE 5-1
Break-even chart:
Leveraged firm
FIGURE 5-2
Break-even chart:
Conservative firm
TABLE 5-2
Volume-cost-profit analysis:
Leveraged firm
TABLE 5-3
Volume-cost-profit analysis:
Conservative firm
FIGURE 5-3
Nonlinear break-even
analysis
Operating Leverage

 Measure of the amount of fixed operating costs used by

a firm.
 Degree of Operating Leverage (DOL) = % in EBIT
(or Operating Income) / %  in Sales

DOL = Q(P-VC) / (Q(P-VC) –FC)

 Operating Leverage measures the sensitivity of a firm’s

operating income to a  in sales.
TABLE 5-4
Operating income or
loss
Financial Leverage

 Measure of the amount of debt used by a firm

 Degree of Financial Leverage (DFL) = % in EPS /
%  in EBIT (or Operating Income)

 DFL = EBIT / (EBIT –I)

 Financial Leverage measures the sensitivity of a firm’s

earnings per share to a  in operating income
Leverage Means Risk

 Leverage is a double-edged sword

 It magnifies profits as well as losses
 An aggressive or highly leveraged firm has high fixed costs
(and a relatively high break-even point)
 A conservative or non-leveraged firm has low fixed costs
(and a relatively low break-even point)
 Many Japanese firms tend to be highly leveraged
FIGURE 5-4
Financing plans and
earnings per share
TABLE 5-5
Impact of financing
plan on earnings
per share
Financial Leverage
 Reflects the amount of debt used in the capital structure of
the firm
 Determines how the operation is to be financed
 Determines the performance between two firms having equal
operating capabilities

BALANCE SHEET
Assets Liabilities and Net Worth
Operating leverage Financial leverage
TABLE 5-6
Income statement
Combined or Total Leverage

 Represents maximum use of leverage

 Degree of Combined or Total Leverage (DCL or
DTL) = % in EPS / % in Sales
 DCL= Q(P-VC)/(Q(P-VC)-FC-I)
= (S-TVC) /( S-TVC –FC- I)
 Short-cut formula:
DCL or DTL = DOL x DFL
TABLE 5-7
Operating and
financial leverage
Combining Operating
and Financial Leverage
 Combined leverage: when both leverages allow a firm to
maximize returns
 Operating leverage:
 Affects the asset structure of the firm
 Determines the return from operations
 Financial leverage:
 Affects the debt-equity mix
 Determines how the benefits received will be allocated