Capital Structure: Part 2_M2 Flashcards
What is Operating Leverage?
Operating leverage =
Q(S − VC)
Q(S − VC) − FC
where:
Q = Quantity
FC = Fixed cost
VC = Variable cost
S = Selling price
What is HIGH operating leverage?
- High operating leverage = high FC=more profitability than firms with high VC.
- Has the risk of covering fixed costs regardless of sales.
- Once fixed costs are recovered, the additional contribution margin goes to operating income.
What is LOW operating leverage?
- Low operating leverage = high VC = less profit.
- Less risk and less potential return are consistent with a company that has low operating leverage, implying low fixed costs and relatively higher variable costs.
- A firm that has low operating leverage will need more additional sales to increase profits than a company with high operating leverage.
What is financial leverage?
- The use of debt to finance operations.
- The effects of percentage change in earnings before interest and taxes (EBIT) on the percentage change in its EPS.
- When issuing debt, the company must produce sufficient EBIT to cover its fixed interest costs.
- Once fixed interest costs are covered, additional EBIT will go directly to net income and EPS.
- higher percentage of fixed financing cost.
- It is a function of decisions made by management.
- Decisions are often the result of industry characteristics.
What is Financial Leverage?
Financial leverage =
EBIT /
EBIT − I − [P ÷ (1 − t)]
where:
I = Interest expense
P = Preferred dividends
t = Tax rate
EBIT = Earnings before interest and taxes
EBIT= Sales - VC - FC Sale = QTY x Price,VC= QTY x VC Price, FC=Given
What is Total Leverage?
Total leverage =
Q(S − VC) /
Q(S − VC) − FC − I − [P ÷ (1 − t)]
where:
Q = Quantity
FC = Fixed cost
VC = Variable cost
S = Selling price
I = Interest expense
P = Preferred dividends
t = Tax rate
How to analyze the debt ratio?
liabilities/assets
- is a measure of a company’s solvency (ability to meet long-term obligations).
- The lower the ratio is, the lower the risk from the perspective of a creditor.
- The lowest debt ratio, the least risky from the perspective of creditors.