(37) Measures of Leverage Flashcards
LOS 37. a: Define and explain leverage, business risk, sales risk, operating risk, and financial risk and classify a risk. Define leverage.
Leverage increases the risk and potential return of a firm’s earnings and cash flows.
LOS 37. a: Define and explain leverage, business risk, sales risk, operating risk, and financial risk and classify a risk. Define operating leverage.
Operating leverage increases with fixed operating costs.
LOS 37. a: Define and explain leverage, business risk, sales risk, operating risk, and financial risk and classify a risk. Define financial leverage.
Financial leverage increases with fixed financing costs.
LOS 37. a: Define and explain leverage, business risk, sales risk, operating risk, and financial risk and classify a risk. Define sales risk.
Sales risk is uncertainty about the firm’s sales.
LOS 37. a: Define and explain leverage, business risk, sales risk, operating risk, and financial risk and classify a risk. Define business risk.
Business risk refers to the uncertainty about operating earnings (EBIT) and results from variability in sales and expenses. Business risk is magnified by operating leverage.
LOS 37. a: Define and explain leverage, business risk, sales risk, operating risk, and financial risk and classify a risk. Define financial risk.
Financial risk refers to the additional variability of EPS compared to EBIT. Financial risk increases with greater use of fixed cost financing (debt) in a company’s capital structure.
LOS 37. b: Calculate and interpret the degree of operating leverage, the degree of financial leverage, and the degree of total leverage.
LOS 37. b: Calculate and interpret the degree of operating leverage, the degree of financial leverage, and the degree of total leverage.
LOS 37. b: Calculate and interpret the degree of operating leverage, the degree of financial leverage, and the degree of total leverage.
LOS 37. b: Calculate and interpret the degree of operating leverage, the degree of financial leverage, and the degree of total leverage. When discussing measures of leverage, what two terms are used interchangeably?
The terms “earnings per share” (EPS) and “net income” are used interchangeably.
LOS 37. b: Calculate and interpret the degree of operating leverage, the degree of financial leverage, and the degree of total leverage. What is the best way to interpret DOL, DFL, and DTL?
Look back at the formulas for DOL and DFL and convince yourself that if there is no fixed costs, DOL is equal to one, and that if there is no interest costs, DFL is equal to one. Values of one mean no leverage. This should help tie these formulas to the concepts and help you know when you have the formulas right (or wrong). If you plug in zero for a fixed costs, DOL should be one, and if you plug in zero for interest, DFL should be one.
LOS 37. c: Analyze the effect of financial leverage on a company’s net income and return on equity.
Using more debt and less equity in a firm’s capital structure reduces net income through added interest expense but also reduces net equity. The net effect can be to either increase or decrease ROE.
LOS 37. c: Analyze the effect of financial leverage on a company’s net income and return on equity. Explain how this relationship is reflected in the DuPont formula used to analyze ROE.
Recall how this relationship is reflected in the DuPont formula used to analyze ROE. One of the components of the DuPont formula is the equity multiplier (assets/equity), which captures the effect of financial leverage on ROE.
LOS 37. d: Calculate the breakeven quantity of sales and determine the company’s net income at various sales levels.
The breakeven quality of sales is the amount of sales necessary to produce a net income of zero (total revenue just covers total costs) and can be calculated as:
(fixed operating costs + fixed financing costs) / (price – variable cost per unit)
LOS 37. d: Calculate the breakeven quantity of sales and determine the company’s net income at various sales levels.
Net income at various sales levels can be calculated as total revenue (i.e., price x quantity sold) minus total costs (i.e., total fixed costs plus total variable costs).
LOS 37. e: Calculate and interpret the operating breakeven quantity of sales. Describe the breakeven analysis for a low and high leveraged company.
LOS 37: Measures of Leverage: Describe quantitatively the impacts of leverage on ROE. Go through the steps.
