LEVERAGE

FINANCIAL MARKETS
LEVERAGE
LEVERAGE
OPERATING LEVERAGE

 This part of a company’s fixed costs reveals how effectively

revenue from sales is translated into operating income. A
business with a high level of operating leverage can increase
its bottom line significantly with just a relatively small
increase in revenues because it has effectively leveraged its
operating costs so as to maximize profits.
DEGREE OF OPERATING LEVERAGE

FORMULA:
CONTRIBUTION MARGIN
EBIT
DEGREE OF OPERATING LEVERAGE

USE:

% CHANGE IN SALES X DOL = % CHANGE IN EBIT

EXAMPLE OF EFFECT OF
DOL
FINANCIAL LEVERAGE

 Financial leverage is a metric used to evaluate

the extent to which a company uses debt to
increase its assets and net income. Examining
a company’s financial leverage shows the
impact on earnings per share of changes in
EBIT that result from taking on additional
debt.
SOME TOOLS TO USE TO CHECK A
COMPANY’S LEVERAGE
 DEBT TO ASSETS RATIO – TOTAL DEBT / TOTAL ASSETS ( THE HIGHER THE
DTA, THE HIGHER THE LEVERAGE
 DEBT TO EQUITY RATIO – TOTAL DEBT / TOTAL EQUITY (A debt-to-equity ratio
greater than one means a company has more debt than equit )
 EQUITY MULITPLIER – TOTAL ASSETS / TOTAL EQUITY ( USED IN DUPONT
ANALYSIS IN GETTING THE ROE. THE HIGHER THE EM, THE HIGHER THE
LEVERAGE)
SUPPLEMENTAL TOPICS

 FINANCIAL DISTRESS – BANKRUPTCY COSTS – DIRECT AND INDIRECT

 DEBTS AND TAXES – TAX SHIELD BENEFIT, TAX PROVISIONS

 PAYOUT POLICY – DIVIDEND PAY OUT POLICY

 OPTIMAL CAPITAL STRUCTURE – TRADE-OFF THEORY AND PECKING ORDER

THEORY - PARRINO BOOK