20.4: The Effects of Operating and Financial Leverage Flashcards
What is operating leverage?
Operating leverage refers to the increased volatility in operating income caused by fixed operating costs.
It occurs when a company uses fixed costs in its operations, which amplifies the impact of sales changes on its operating income.
How does operating leverage affect a firm’s net income?
Operating leverage causes net income to change more than proportionately with sales changes.
For example, a 20% increase in sales can lead to a 35% increase in net income due to fixed costs.
What is financial leverage?
Financial leverage is the use of fixed financial costs (like debt interest) to magnify the effects of changes in operating income on net income.
It affects the firm’s earnings per share (EPS) and return on equity (ROE).
How does financial leverage impact a firm’s risk?
Financial leverage increases the firm’s risk by amplifying the effects of operating income changes on the firm’s net income, which can lead to higher volatility in earnings and returns for shareholders.
What is the formula for measuring operating leverage?
Degree of Operating Leverage (DOL) = Contribution Margin / Earnings Before Interest and Taxes (EBIT)
where:
- Contribution Margin = Sales - Variable Costs
What is the formula for measuring financial leverage?
Degree of Financial Leverage (DFL) = EBIT / (EBIT - Interest)
What is combined leverage?
Combined leverage is the total impact of both operating and financial leverage on a company’s earnings, indicating how sensitive net income is to changes in sales.
How is the Degree of Combined Leverage (DCL) calculated?
DCL = DOL * DFL
where:
- DOL = Degree of Operating Leverage
- DFL = Degree of Financial Leverage
In the given example, what happens to the net income if sales increase by 20%?
In the example, sales increase by 20% from $1,000 to $1,200, leading to a net income increase of 35% from $300 to $405 due to operating leverage.
What is the impact of a 20% sales decrease on net income in the example provided?
A 20% decrease in sales from $1,000 to $800 results in a 35% decrease in net income from $300 to $195 due to fixed financial costs, showcasing financial leverage.
Distinguish between operating and financial leverage.
Operating leverage is related to fixed operational costs affecting operating income, while financial leverage involves fixed financial costs (interest) affecting net income.
Why do we say that equity holders bear the brunt of the effects of leverage?
Equity holders bear more risk due to leverage as both operating and financial leverage increase the volatility of earnings, impacting their returns more significantly than other stakeholders.
