LEVERAGE ANALYSIS

LEVERAGE
y Results from the use of fixed-cost assets or

funds to magnify returns to the firm s owners.

y Generally:
y Increases in leverage result in increased return and risk y Decreases in leverage result in decreased return and risk

LEVERAGE
y The amount of leverage in the firm s capital structure

can significantly affect its value by affecting return and risk. y Unlike some causes of risk, management has almost complete control over the risk introduced through the use of leverage. y Because of its effect in value, the financial manager understand how to measure and evaluate leverage, particularly in making capital structure decision.
y **CAPITAL STRUCTURE the mix of long-term debt and equity maintained by the firm

THREE BASIC TYPES

y1. OPERATING LEVERAGE y2. FINANCIAL LEVERAGE y3. TOTAL LEVERAGE

General Income Statement Format and Types of Leverage

Sales Revenue Less: Cost of Goods Sold Gross Profit Less: Operating Expenses Earnings before interest and Taxes (EBIT) Less: Interest Net Profits before taxes Less: Taxes Net Profits after taxes Less: Preferred stock dividends Earnings Available for common stockholders Earnings per share (EPS)
T o t a l L e v e r a g e

Operating Leverage

Financial Leverage

Operating Leverage
y Is the ratio of a company s level of fixed costs to total

costs at different levels of safety or activity. y A company has a high operating leverage if its costs is consists mainly of fixed costs
y FOR EXAMPLE: y A capital-intensive plant has a high operating leverage.

Another company may choose to set up its plant as a high labor, low capital plant. Such a company has a low operating leverage.

y The use of fixed cost to make operations more efficient

Operating Leverage
y The measure of operating leverage is the degree of

operating leverage (DOL). y DOL is the percentage change in profit for each percentage change in output. y FORMULA:
Degree of Operating = Percentage change in profit Leverage Percentage change in output * = Contribution Margin EBIT = Sales Total Variable Cost Sales Total Variable Cost Total Fixed Costs

Operating Leverage
y DOL is the counterpart of the concept elasticity in basic

economics. y It measures the responsiveness of profits to a change in the level of output. y Since fixed costs does not change with output, DOL will have values at different volumes of output as follows:
y (a) positive above the break-even sales volume y (b) negative below the break-even sales volume and; y (c) zero at zero sales volume

y DOL decreases as the volume of output increases.

Operating Leverage
y Illustrative Example: y Two companies producing identical products for the same markets have the following costs and sales levels:
ABC Co. Total Variable Costs (P) Total Fixed Costs (P) Total Sales Volume (units) Total Sales (P) 500,000 1,000,000 10,000 2,000,000 XYZ Co. 1,200,000 300,000 10,000 2,000,000

The management of the two companies would want to determine their respective degrees of leverage at these sales level