L.34 Measures of leverage

Question 1

Learning outcomes

Answer 1

a. Define and explain leverage, business risk, sales risk, operating risk, and financial risk and classify a risk
b. Calculate and interpret the degree of operating leverage, the degree of financial leverage, and the degree of total leverage
c. Analyze the effect of financial leverage on a company’s net income and return on equity
d. Calculate the breakeven quantity of sales and determine the company’s net income at various sales levels
e. Calculate and interpret the operating breakeven quantity of sales

Question 2

Leverage

Answer 2

The use of fixed costs in a company’s cost structure

• fixed costs that are operating costs creating operating leverage
• fixed costs that are financial costs create financial leverage

Understand use of leverage for 3 reasons
1. degree of leverage is an important component in assessing a company’s risk and return characteristics

2. analysts able to discern information about a company’s business and future prospects from management’s decisions about the use of operating and financial leverage
3. valuation of a company requires forecasting future cash flows and assessing the risk associated with those cash flows - understanding the use of leverage can help in forecasting
   - leverage increase the volatility of a company’s earnings and cash flows and increases the risks of lending or owning a company
   - the greater a company’s leverage, the greater its risks
   - companies that have more fixed costs relative to variable costs in their cost structures have greater variation in net income as revenues fluctuate = more risk

Question 3

Types of risk

Answer 3

1. business risks
   - associate with operating earnings
   - combination of operating risk and sales risk
2. operating risk
   - attributed to the operating cost structure
   - greater the fixed operating costs vs variable operating costs = the greater the operating risk
3. sales risks
   - uncertainty with respect to price and quantity of goods and services
4. financial risks

Question 4

Operating risks

Answer 4

• elasticity is a measure of the sensitivity of changes in one item to changes in another
• examine how sensitive a company’s operating income is to changes in demand, we can calculate operating income elasticity aka degree of operating leverage (DOL); quantitative measure of operating risk

DOL = % change in operating income / % change in units sold

if DOL at a given level of unit sales is 2.0, 5 percent increase in units from that level will be 2 x 5% = 10% increase in operating income

EG. operating income increases 26.67% when units sold increase by 10%

this means that for 1 % change in units sold, operating income change by 2.67 that percentage
ie if 10% increase in units sold, 26.67% increase in operating income

operating income = (price/unit * # units sold) - (variable cost/ unit) * # of units sold) - fixed operating costs

Per unit contribution margin is the amount that each unit sold contributes to covering fixed costs or the difference between the price/unit and the variable costs

• the difference multiplied by the total qty sold = contribution margin, which also is the revenue minus variable cost

DOL = Q(P-V) / Q(P-V) - F
where Q is the # of units, P is price/unit, V is variable operating cost/unit and F is fixed operating cost

therefore P-V is per unit contribution margin and Q(P-V) is the contribution margin

Question 5

Financial risk

Answer 5

Risk associated with how a company finances its operations

• the more fixed cost financial obligations (eg debt) incurred by the company, the greater its financial risk
• sensitivity of cash flows available to owners when operating income change known as degree of financial leverage (DFL)

DFL = % change in net income / % change in operating income

• net income = operating income less interests and taxes

DFL = [Q (P - V) - F] / [Q (P - V) - F - C]

• the greater use of financing sources that require fixed obligations, the greater the sensitivity of net income to changes in operating income

Question 6

Total leverage

Answer 6

Combining a company’s degree of operating leverage with its degree of financial leverage results in the degree of total leverage (DTL)

• measures sensitivity of net income to changes in the number of units produced and sold

DTL = % change in net income/ % change in number of units sold

DTL = Q(P - V) / Q (P - V) - F - C

if DTL is 4, it means that 1% increase in units sold will result in 4% increase in net income

EG so if 50% increase in units produced and sold = 200% increase in net income

• for operating leverage, the greater the proportion of operating costs are fixed, the more sensitive operating income is to changes in sales
• for financial leverage, the greater the proportion of financing with fixed cost sources, the more sensitive cash flows available to owners are to changes in operating income

Question 7

Breakeven point

Answer 7

• the number of units produced and sold at which the company’s net income is zero; the point at which revenues are equal to costs

Qbe = F + C / P - V

• operating breakeven point is where the number of units produced and sold at which the company’s operating PROFIT is 0.

QoBE = F / P - V