1.4 Leverage Flashcards
This year, an entity increased earnings before interest and taxes (EBIT) by 17%. During the same period, net income after tax increased by 42%. The degree of financial leverage that existed during the year is
A. 1.70
B. 4.20
C. 2.47
D. 5.90
C. 2.47
The percentage-change version of the degree of financial leverage equals the percentage change in net income over the percentage change in EBIT. Accordingly, the entity’s degree of financial leverage is 2.47 (42% ÷ 17%).
A firm with a higher degree of operating leverage when compared to the industry average implies that the
A. Firm has higher variable costs.
B. Firm’s profits are more sensitive to changes in sales volume.
C. Firm is more profitable.
D. Firm is less risky.
B. Firm’s profits are more sensitive to changes in sales volume.
Operating leverage is a measure of the degree to which fixed costs are used in the production process. A company with a higher percentage of fixed costs (higher operating leverage) has greater risk than one in the same industry that relies more heavily on variable costs. However, such a firm is also able to expand production rapidly in times of higher product demand. Thus, the more leveraged a firm is in its operations, the more sensitive operating income is to changes in sales volume.
Everything else being equal, a A highly leveraged firm will have B earnings per share.
A. More, Lower
B. More, Less volatile
C. Less, Less volatile
D. Less, Higher
C. Less, Less volatile
Earnings per share is less volatile in less highly leveraged firms. Lower fixed costs result in less variable earnings when sales fluctuate.
Causes of operating levearage
Use of high level of plant assets and machinery in the production process, revealed through charges for depreciation, property taxes, etc.
Formula for degree of operating leverage (DOL)
Degree of operating leverage = contribution margin / operating income or EBIT
For a firm with a degree of operating leverage of 3.5, an increase in sales of 6% will
A. Decrease pre-tax profits by 3.5%.
B. Increase pre-tax profits by 1.71%.
C. Increase pre-tax profits by 21%.
D. Increase pre-tax profits by 3.5%.
C. Increase pre-tax profits by 21%.
A degree of operating leverage (DOL) of 3.5 means that operating income (EBIT) will increase 3.5 times greater than any sales increase. Multiplying 3.5 times the 6% sales increase results in a pre-tax profit increase of 21%.
An accountant has determined that last year a company had earnings before interest and tax of $750,000, interest expense of $125,000, and an income tax rate of 40%. What was the company’s degree of financial leverage last year?
A. 2.00
B. 0.80
C. 1.20
D. 1.67
C. 1.20
The degree of financial leverage can be calculated as
EBIT / Earnings before taxes
= 750,000 / (750,000 - 125,000) = 1.20
Since incorporating 3 years ago, a company has estimated credit losses at a rate of 3% using the income statement approach. During its fourth year in business, after recording the uncollectible accounts expense based on its previous estimate, the company determined that its estimate of uncollectible accounts should be increased to 4.5%. During this fourth year, the company recorded sales of $25,000,000 and had an ending accounts receivable balance of $2,000,000. This change would decrease
A. The current year’s income by $1,125,000 and decrease the firm’s operating leverage.
B. Both operating leverage and times interest earned.
C. The current year’s income by $375,000 and increase the firm’s operating leverage.
D. The current year’s income by $30,000 and decrease the firm’s financial leverage.
C. The current year’s income by $375,000 and increase the firm’s operating leverage.
The company increased its credit loss expense by 1.5% for the current year. This increase would cause a decrease in income of $375,000 [25,000,000 x (4.5% - 3%)]. Because the company used the income statement approach of calculating credit losses, the accounts receivable balance of $2,000,000 is irrelevant. This decrease in income will cause both numerator (contribution margin) and the denominator (operating income) of the firm’s operating leverage to decrease by a proportional amount. However, this proportional decrease will cause the overall leverage to increase.
Financial information for 2 years of operation is shown below.
Sales
Year1: $4,000,000
Year2: $4,400,000
Total operating costs
Year1: 3,200,000
Year2: 3,440,000
Earnings before interest and taxes
Year1: $ 800,000
Year2: $ 960,000
Interest payments
Year1: 320,000
Year2: 275,000
Income taxes
Year1: 245,000
Year2: 354,000
Net income
Year1: $ 235,000
Year2: $ 331,000
Earnings per share
Year1: $ 2.35
Year2: $ 3.31
The degree of operating leverage (DOL) is
A. 2.00
B. 2.67
C. 0.75
D. 4.09
A. 2.00
The percentage-change version of DOL measures the change in income statement amounts from one period to another. This can be expressed as the percentage change in EBIT over the percentage change in sales.
The percentage change in EBIT is equal to 20% [($960,000 - 800,000) / 800,000]. The percentage change in sales is equal to 10% [($4,400,000 - $4,000,000) / $4,000,000]. Therefore, the DOL is equal to 2.00 (20% / 10%).
A degree of operating leverage of 3 at 5,000 units means that a
A. 3% change in earnings before interest and taxes will cause a 3% change in sales
B. 1% change in sales will cause a 3% change in earnings before interest and taxes
C. 1% change in earnings before interest and taxes will cause 3% change in sales
D. 3% change in sales will cause a 3% change in earnings before interest and taxes
B. 1% change in sales will cause a 3% change in earnings before interest and taxes
The degree of operating leverage (DOL) is the multiple of contribution margin over operating income (also called earnings before interest and taxes, or EBIT). A high multiple indicates heavy use of fixed costs in the firm’s operations. The firm’s contribution margin is 3 times EBIT. Thus, a given percentage change in sales will results in a change 3 times as great in EBIT.
Operating vs. Financial leverage
Operating leverage refers to the level of fixed assets in a firm and the decrease in variable costs as fixed costs increase. It is calculated as contribution margin divided by operating income or EBIT.
Financial leverage is the ratio of debt to the total value of the firm, referring to the degree to which the assets of the firm are financed with debt and subsequent effect of interest payment. It can be calculated as operating income or EBIT divided by EBT.
At least two implication of increasing operating and financial leverage include
- The firm’s competitiveness and market share may increase. In many firms, higher volumes with lower prices are only possible with investment in automation.
- With a high degree of leverage, particularly financial leverage, lenders will require a higher interest rate due to the perceived increase in risk, therefore increasing the cost of debt to the firm.
Financial leverage arises from the..
Financial leverage arises from the use of a high level of debt in the firm’s financing structure, revealed through amounts paid out for interest.
Formula for Degree of Financial Leverage
- EBIT / EBT
- % change in net income / % change in EBIT
The use of debt in the capital structure of a firm
A. Increases its financial leverage
B. Increases its operating leverage
C. Decreases its financial leverage
D. Decreases its operating leverage
A. Increases its financial leverage
Financial leverage is the use of fixed costs in a firm’s capital structure, indicated by high interest payments on debt. These increased fixed costs (and accompanying lowered variable costs) make profitable periods more profitable and unprofitable periods worse.
