Measures of Leverage Flashcards
Explain leverage
the amount of fixed costs a firm has
Explain business risk
refers to the risk associated with a firm’s operating income and is the result of uncertainty about a firm’s revenues and the expenditures necessary to produce those revenues. Business risk is the combination of sales risk and operating risk.
Explain sales risk
the uncertainty about the firm’s sales.
Explain operating risk
the additional uncertainty about operating earnings caused by fixed operating costs. The greater the proportion of fixed costs to
variable costs, the greater a firm’s operating risk.
Explain financial risk
the additional risk that the firm’s common stockholders must bear when a firm uses fixed cost (debt) financing. When a company finances its
operations with debt, it takes on fixed expenses in the form of interest payments. The
greater the proportion of debt in a firm’s capital structure, the greater the firm’s financial risk.
Degree of operating leverage (DOL) =
(Revenues - variable operating costs) / (revenues - variable operating costs - fixed operating costs)
To calculate a firm’s DOL for a particular level of unit sales, Q, DOL is:
[Q(P-V)] / [Q(P-V)-F]
%change in EBIT / %change in sales
Degree of financial leverage (DFL)
The ratio of the percentage
change in net income (or EPS) to the percentage change in EBIT
For a particular level of operating earnings, DFL is calculated as:
EBIT / (EBIT-interest)
Degree of total leverage (DTL)
DTL measures the sensitivity of EPS to change in sales.
DTL is computed as
DOL x DFL
Breakeven Quantity
The level of sales that a firm must generate to cover all of its fixed and variable costs
Breakeven quantity of sales
the quantity of sales
for which revenues equal total costs, so that net income is zero.
Contribution margin
the difference between price and variable cost per unit, is available to help cover fixed costs.
Breakeven quantity of sales, Q(BE) =
(fixed operating costs + fixed financing costs) / (price - variable cost per unit)
Operating breakeven quantity of sales, Q(OBE) =
Fixed OC / (Price - variable cost per unit)
Cost structure
The mix of a company’s VC and FC
Elasticity
The %change in one variable for a %change in another variable; a general measure of how sensitive one variable is to a change in another variable.
Net profit margin
ROA / Asset turnover
Financial leverage
ROE / ROA
Inventory turnover
Cost of sales / Average inventory
Working capital turnover
Revenue / Average working capital
Fixed asset turnover
Revenue / Average net fixed assets
Total asset turnover
Revenue / Average total assets
Days of sales outstanding (DSO)
Number of days in period / Receivables turnover
Working capital
The difference between current assets and current liabilities.
Degree of operating leverage definition
The ratio of the percentage change in operating income to the percentage change in units sold; the sensitivity of operating income to changes in units sold.
