1.4 Leverage

Question 1

Leverage

Answer 1

The relative amount of fixed cost in a firms overall cost structure. Leverage creates risk because fix cost must be covered. Regardless of the level of sales

Operating Leverage-High level of plant and machinery in production process, revealed through charges for depreciation and property taxes

Financial leverage-High level of debt in the firms financing structure. Revealed through amounts paid out of interest

Leverage arises from items on the balance sheet. Measured by examining effects on income statement

General statement of leverage is

Degree of leverage=

Pre-fixed cost income amount/
Post fixed cost Income amount

Question 2

Degree of operating Leverage

Answer 2

Contribution margin/
Operating income or EBIT

Delta EBIT/
Delta Sales

Question 3

Degree of operating leverage

Two formulas

Answer 3

Contribution margin/
Operating income or EBIT

This is used for a single period Analysis. Note that this is not a percent. Like below

Delta operating income or EBIT/
Delta sales

Measures changes from one period to the next.
This method is necessary when finance reports are prepared on absorption basis.

New subtract old/
Old

The DOL percent means for every 1% change in sales there is a X percent change in EBIT

Question 4

Degree of Operating Leverage analysis

Answer 4

Firm with high operating Leverage carries a greater degree of risk because fixed cost must be covered. But such a firm is also able to expand Production rapidly and times of higher demand. Maybe because it has more equipment. That’s the more leverage the firm is in its operations more sensitive operating income is the changes in sales volume

Question 5

Degree of financial leverage

DFL

Answer 5

Earnings before interest and taxes/earnings before taxes

Single period method
EBIT/
EBT

The results e.g. 1.11 means that it needs 1.11 of EBIT to generate one dollar of EBT

Also: a percent change in EBIT
Is dol x % = change in EBT
Percentage change version

Change in net income/
Change in EBIT

Isolates the effects of interest as the only true fixed financing

Question 6

Calculate the effect of a percent increase in sales on the EBIT using degree of operating Leverage

Answer 6

Calculate Leverage

CM/EBIT

300/100= 3

Delta EBIT/
Delta Sales

200/400 = 2

10 Percent change

10% x 3 = 30%

Sales x 30% = EBIT change. Or

Operating Income start x 1.3 Because new operating income