Leverage Flashcards
What is leverage?
Leverage is the relative amount of fixed cost in a firm’s overall cost structure. Leverage creates risk because fixed costs must be covered, regardless of the level of sales
What is Operating leverage?
Operating leverage arises from the use of a high level of plant and machinery in the production process revealed through charges for depreciation, property taxes, etc.
What is Financial leverage?
Financial leverage arises from the use of a high level of debt in the firm’s financing structure revealed through amounts paid for interest
What is the Degree of leverage formula?
Single-period version
Although leverage arises from items on the balance sheet, it is measured by examining its effects on the income statement:
Degree of leverage =
Pre- fixed-cost income amount / Post-fixed cost income amount
What is the Degree of operating leverage (DOL)?
Calculation of the DOL requires financial information prepared on the variable-costing basis, since variable costing isolates the use of fixed costs in the firm’s ongoing operations:
DOL (Single-period version) =
Contribution margin / Operating income or EBIT
A firm’s DOL varies with the level of sales and DOL is NOT a meaningful measure when the firm incurs an operating loss
What are the two version of degree of operating leverage (DOL) being used?
One version compares contribution margin and variable-basis operating income in a single reporting period
The percentage-change version of DOL measures the changes in income statement amounts from one period to another
What is the Degree of operating leverage (DOL)?
Percentage-change version
DOL percentage-change formula =
%∆ in Operating Income or EBIT / %∆ in Sales
The %-change version is necessary when the only financial reports available are those prepared on the absorption basis
The numerator and denominator are different from those in the single-period version
What are the effects of a firm that has a high degree of operating leverage?
A firm with a high operating leverage necessarily carries a greater degree of risk because fixed costs must be covered regardless of the level of sales
However, such a firm is also able to expand production rapidly in times of higher product demand. Thus, the more leveraged a firm is in its operations, the more sensitive operating income is to changes in sales volume
What are the effects of a firm that has a high degree of operating leverage?
A firm with a high operating leverage necessarily carries a greater degree of risk because fixed costs must be covered regardless of the level of sales
However, such a firm is also able to expand production rapidly in times of higher product demand. Thus, the more leveraged a firm is in its operations, the more sensitive operating income is to changes in sales volume
What is Degree of financial leverage (DFL)?
Single-period version
The DFL results from a pre-fixed-cost income to post-fixed-cost income comparison (like operating leverage), but on the firm’s financing structure:
= EBIT / EBT (Earnings before taxes)
Note: This formula isolates the effects of interest as the only truly fixed financing cost
What are the two version of degree of financial leverage (DFL) being used?
One version compares EBIT and EBT from a single reporting period
The percentage-change version of DFL examines the changes in income statement amounts over two periods
What is Degree of financial leverage (DFL)?
Percentage-change version
DFL percentage-change formula =
%∆ in Net Income / %∆ in EBIT
The numerator and denominator are different from those in the single-period version
What are the effects of a firm that has a high degree of financial leverage?
A firm with high financial leverage necessarily carries a greater degree of risk because debt must be serviced regardless of the level of earnings
However, if such a firm is profitable, there is more residual profit for the shareholders after debt service (interest on debt is tax-deductible), reflect in higher EPS
Also, debt financing permits the current equity holders to retain control
