CHAPTER 6

ANALYSIS LEVERAGE
• Leverage means using fixed costs or fixed expenses to increase
profitability
• Leverage deals with the different types of financing and indicates the
amount of debt used to support the firm resources and operation
• Increases leverage would result increase return and risk.
• Risk – relative dispersion in the firm’s expected EBIT
• Business Risk – it concerned with the uncertainty associated with an
investment earnings and the firms ability to pay interest, principal,
dividend and other returns to investors
• Financial Risk – the firm inability to meet its debt obligation as they
come due. Decision using financial leverage will expose the common
shareholder to financial risk
• Leverage consists:-
i) Operating Leverage
ii) Financial Leverage
 Operating Leverage
• It deals with business risk
• If high percentage of the firm costs, is fixed cost and does not
decline when sales decline, then its exposed to high degree of
business risk
• When there is operating leverage, changes in sales will cause
changes in EBIT
• It means operating leverage measures the effect on EBIT for any
changes in sales
Degree of Operating Leverage

• It is a quantitative measure of the sensitivity of a firms’ operating

profit (EBIT) to a change in the firms sales

Syarikat Benar Belaka

Sales 400,000
Less: Variable Cost 240,000

Contribution Margin 160,000

Less: Fixed Cost 100,000
EBIT 60,000

Sales = Selling Price per unit x Quantity

Variable Cost = Variable Cost per unit x Quantity
APPROACH DOL

DOL = Q(SP – VC) = Sales – VC = Contribution

Q(SP – VC)- FC Sales – VC – FC EBIT

DOL = Percentage change in EBIT

Percentage change in Sales

• The greater the firm’s DOL, the more its profit will vary with a given
percentage change in sales
• EBIT is shown to be sensitive to the changes in sales. When sales
increased by xx%, the EBIT increased by xx%
 IMPLICATION AND CONCLUSION
Manager can use DOL to assist him:-

i) Planning Targeted Profits

• The manager can estimate how EBIT will fluctuate for any
changes in sales

ii) Changing the cost structure to maximize profits

• The higher the DOL, the more profits will fluctuate for a given
percentage in sales
• If sales are expected to continually increase in the future, the
operating costs can be manipulated to increase the DOL
 Financial Leverage
• It is expressed as the ratio of debt to equity
• The higher the debt ratio, the greater the financial leverage
• It also refers to the sensitivity of net profit after tax from using fixed
income securities such as long-term debt and preferences shares
• It employed in hope of increasing the returns to common
shareholders
• Positive financial leverage – firm uses funds obtained at a fixed cost
to earn more than the fixed financing cost paid
• Any profit remaining after meeting the fixed financing costs
would belong to the ordinary shareholders
• Negative financial leverage – when the firm does not earn enough
to cover the fixed financing costs
• Financial leverage affects the earnings after interest and tax or
earnings available to common shareholders or EPS
• Changes in EBIT (increase or decrease) translate into larger
changes (EPS)
Degree of Financial Leverage (DFL)

• It measures the percentage change in the earning per share (EPS)

as a result of a percentage change in earnings before interest and
tax (EBIT)
• It measures the sensitivity of the firms EPS to a change in the firm
EBIT

Syarikat Benar Belaka

Sales 400,000
Less: Variable Cost 240,000

Contribution Margin 160,000

Less: Fixed Cost 100,000
EBIT 60,000
Interest 10,000
EBT 50,000
Tax (10%) 5,000
EAT 45,000
APPROACH DFL

DFL = EBIT
EBIT – Interest

DFL = Percentage change in EPS

Percentage change in EBIT

• EPS is shown to be sensitive to the changes in EBIT. When EBIT

increased by xx%, the EPS increased by xx%
 Implications and Conclusion
• When financial manager is considering the type of financing
to choose, he has to consider the impact to common
shareholders

• The higher the DFL, the greater the fluctuation in EPS – the
common shareholder has to suffer greater variation in returns
if firm decided to employ more leverage
 Combination of Operating and Financial
Leverage
• Change in Sales into a larger change in EPS
• The combined leverage allows the financial managers to measure
the effects and risks of using financial leverage in addition to
operating leverage
• A company is highly levered if it employs a higher level of both
operating and financial leverages.
• A small change in the level of sales, would result in a greater
fluctuation in the EPS

• APPROACH DCL

DCL = DOL x DFL

DCL = Percentage change in EPS
Percentage change in Sales
 Break-even Analysis
• It also known as cost-volume-profit analysis to determine the sales
level at which the firm neither incur a loss nor makes a profit
• Total costs = net sales revenues
• Financial manager will be able to determine the quantity of output that
must be produced and sold to cover all the operating costs and to
determine the EBIT that can be achieved at various levels of outputs
• At break even point, EBIT (operating profit) equals to zero

Break-even point (units) = Fixed Cost

Contribution Margin per unit (SP per-unit – VC per-unit)

Break-even point (ringgit)= Fixed Cost

Contribution Margin sales ratio (CM/sales)

Break-even point (ringgit) = units x sales price per unit

 SELF TEST PROBLEM I
Power Rangers Sdn Bhd had developed the following analytical profit
and loss statement. It represents the operation for the year ended
2016 RM
Sales 32,000,000
Variable costs 19,200,000
Contribution Margin 12,800,000
Fixed Cost 8,000,000
EBIT 4,800,000
Interest Expenses 1,600,000
Earning Before Taxes 3,200,000
Taxes@ 25% 800,000
Net income 2,400,000
Calculate:

a. Break-even point in ringgit

b. Degree of operating leverage
c. Degree of financial leverage
d. Degree of combined leverage
e. Percentage change in EPS if EBIT increase by 25%
f. If the sales should increase by 20%, what percentage would you
expect operating income to increase?