Leverage notes

Dubai Women's College

BADM300

Financial Management

Financial Management Fundamentals Concepts of Operating and Financial Leverage

Leverage in business business is derived from the the word ‘lever’. A lever is a simple tool tool by which a large weight can be moved with a small force. The study of Leverage starts with our understanding of break-even or the point at which a firm covers both fixed and variable costs. OPERATING LEVERAGE

Operating leverage is a measure of the extent to which, fixed operating costs are being used in an organization. organization. It is greatest (largest) in companies that have a high proportion of fixed operating costs in relation relation (proportion) (proportion) to variable variable operating costs. costs. This type of company is using more fixed assets in the operation of the company. Conversely, operating leverage is lowest in companies that have a low proportion of fixed operating costs in relation to variable operating costs. Firms with large amounts of fixed operating costs have high break-even points and high operating operating leverage. Variable cost in these firms tends to be be low and both the contribution contribution (CM) and unit contribution contribution (UC) (UC) margin is high. Formula(s) for calculating Operating leverage :

Degree of Operating Leverage =

Perc Percen entt Chang hange e in Ope Opera ratin ting g

Incom Income e

Perc Percen entt Chan Change ge in Sales Sales

or


Contrib Contributi uti on Margin argin Earni arning ngss Before efore Inte Intere rest st and and Taxe Taxess

or

Degree of Operating Operating Leverage Leverage = Tota Totall Sales Sales Tota Totall Sale Saless

−Tota otal

Compilation:RKVN

−Tota Totall

Vari Variab able le Cost ost

Var Varia iabl ble e Cost Cost

−Tota otal

Operat eratin ing g

Fixed ixed Cost

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or


Q ua w at Ohn ipt c i eth yr a t i n g L e i cvs oe mr ax p g ( uPe t r e ui d−cVn e i a ct roP iu sae) nt br i ltp e e

 Q ua w at Ohn ipt ci eth yr a t i n g   L e i Cvs e o r max (Pgp peru u ei t− cVnre eida t c rp oui e a)sn− r Obt i tl peF e C i r x   Example :

Company A and Company B are competitors in the market for a special machine part. The cost structure and price details are given below:

Selling price Variable cost per unit Fixed costs

Company A AED 30 AED 10 AED 60,000

Company B AED 30 AED 20 AED 20,000

Question : Which firm has a high degree of operating leverage ? Answer :

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C-V-P analysis of Company A and Company B Company A Units sold

Variable costs

Fixed costs

Total costs

Revenue

Operating Income (loss)

Variable costs

Fixed costs

Total costs

Revenue

Operating Income (loss)

0 2,000 3,000 4,000 5,000

Company B Units sold

0 2,000 3,000 4,000 5,000

Calculations of “Degree of Operating Leverage”:

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Implications:

1.

A firm with a high break-even point is more risky than one with a low Break-even point. In periods of increasing sales, operating income (OI or EBIT) of the leveraged firm tends to increase rapidly. This increase in OI (EBIT) is the ‘pay-off’ for being more risky. But in periods of decreasing sales, operating income of the firm tends to decrease rapidly, that is the risk.

2.

Firms with small amounts of fixed operating costs have low break-even points and are therefore less risky and have low operating leverage. Variable costs in these firms tend to be high and both the CM and UC is low. In periods of increasing sales, Operating income (EBIT) for these firms tends to increase slowly. But in periods of decreasing sales, Operating income will tend to decrease slowly making the firm less risky.

3.

In conclusion, if a company has high operating leverage, then the operating income (OI or EBIT) will become very sensitive to changes in sales volume. Just a small percentage (%) chance in sales can yield (produce) a large percentage change in Operating Income. A Company with low operating leverage the reverse is true.

Compilation:RKVN

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FINANCIAL LEVERAGE

Financial leverage is the extent to which debt (liability) is used in the Capital Structure (financing) of the firm. Capital Structure refers to the relationship between assets, debt (liability) and equity. The more debt a firm has relative to equity the greater the financial leverage (these firms have a higher Debt to Asset ratios). Example :

Let us say both companies have the following capital structure: Company A

Company B

Debt (10%) 100,000 Sh. Equity (AED 10 par) 40,000 (4,000 shares) --------Total Capital 140,000

Debt (10%) 40,000 Sh. Equity (AED 10 par) 100,000 (10,000 shares) ---------Total Capital 140,000

Substantial use of debt will place a great burden on the firm at low levels of profitability (low EBIT, since interest must be paid). However, it will also help to magnify (enlarge) increases in earning per share (EPS) as the EBIT or operating income increases. Degree of Financial Leverage =

Percent Change in Earnings Per Share Percent Change in Operating Income

or

Degree of Financial Leverage =

Compilation:RKVN

Earnings Before Interest and Taxes Earnings Before Interest and Taxes

−

Interest

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Calculations of Income statements at different levels of operations: Company A AED Company B AED Sales (4,000 units) Less: Var. costs Fix.costs EBIT Less : Interest EBT Less: Tax (50%) EAT

Sales (4,000 units) Less: Var. costs Fix.costs EBIT Less : Interest EBT Less: Tax (50%) EAT

EPS

EPS

Sales (5,000 units) Less: Var. costs Fixed costs EBIT Less : Interest EBT Less: Tax (50%) EAT

Sales (5,000 units) Less: Var. costs Fixed costs EBIT Less : Interest EBT Less: Tax (50%) EAT

EPS

EPS

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Implications 1. Financial leverage can be very useful to a firm if properly used under the right conditions. For firms in industries that have a degree of stability and/or show growth, the use of debt is recommended because of the positive aspects of financial leverage.

BUT... 2.

As a firm increases the use of debt in its capital structure, creditors (lenders) will perceive a greater financial risk in lending money to the firm and therefore may charge a higher interest rate which may lower earning before tax (EBT). These lenders will perhaps place other restrictions on the firm. Stockholders may become concerned with the risk to EPS and sell the stock (which will force the market price down).

3.

In conclusion, Financial leverage is a very useful tool if used correctly and under the right conditions. At times, the value of the firm is enhanced by financial leverage.

COMBINED LEVERAGE When financial leverage is combined with operating leverage the effect of a change in output (sales) in magnified in the change in earning per share (EPS). Operating leverage gives us the change in EBIT with a change in sales and financial leverage gives us the change in EPS with a change in EBIT. We cam then see the change in EPS for a change in sales (volume of output). The combining both concepts as can be seen below: Operating Leverage is: Change in sales leads to a change in

EBIT

Financial Leverage is:

Change in EBIT leads to a change in EPS Therefore, Combined Leverage is: Change in sales leads to a change in EPS.

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Now, we can determine the effect of a change in output (sales) on earnings per share (EPS). In this way, we can better depict the relative influence of the two types of leverage for the firm. We can determine and examine the effect of adding financial leverage on top of operating leverage. Degree of Combined Leverage =

Percent Change in Earnings Per Share Percent Change in Sales (or volume )

or

Degree of Combined Leverage = Degree of Operating x Degree of Financial Leverage

Leverage

or

Degree of Combined Leverage=

Q auw t aO h n ip tc ei ht r y a t i n g L ei c sv o e m r a p x g u e t ( ep Pdr u i −eVnc r eiac t por u eis) na rt ib t l

 Q auw t aO h n pi tc ei ht r y a t i n g   L ei Csv oe rxm(Pa pgr iue − c utV e n adc i prot )i ues− aO rtn b piF lpt Cee i e −xrI or ane   Calculate the degree of combined leverage for both firms:

Implication:

1.

Remember that a firm with high leverage(s) will have large increases in

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EPS for changes in sales but will also have large decreases in EPS for decreases in sales (and therefore have high risk). 2.

Firms that have lower leverage(s), with have smaller increases in EPS for the same change in sales and will have smaller decreases in EPS for the same decrease in sales (and therefore have lower risk).

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Leverage notes

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