Module 34.1 Measures of Leverage

Question 1

What is operational leverage?

Answer 1

operational leverage is the amount of fixed costs a firm has. greater leverage leads to greater variability of the firm’s after-tax operating earnings and net income.

Question 2

What does business risk mean? Sales risk and operating risk?

Answer 2

business risk - referres to the risk associated with a firms operating income and uncertainty of revenues.

sales risk - uncertainty of a firms sales

operating risk - refers to the additional uncertainty about operating earnings caused by fixed operating costs.

Question 3

What is financial risk?

Answer 3

refers to the additional risk that the firm’s common shareholders must bear when a firm uses fixed cost (debt) financing.

Question 4

What is degree of operating leverage? how is it calculated? how is it calculated for a particular level of unit sales?

Answer 4

degree of operating leverage is percentage change in operating income (EBIT) that results from a given percentage change in sales:

DOL = percentage change in EBIT / percentage change in sales

DOL for unit of sales = Q (P- V) / Q (P-V) - F

q = units sold
p = price per unit
v = variable cost
f = fixed costs

Question 5

What is the degree of financial leverage? what is the formula? for a particular level of operating earnings?

Answer 5

DFL = percentage change in EPS / percentage change in EBIT

for a particular level = EBIT / EBIT - interest

Question 6

What is the degree of total leverage? how is it calculated?

Answer 6

combines degree of operating leverage and financial leverage

DTL = DOL x DFL

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

DTL = S - TVC / S - TVC - F - I

Question 7

What is the breakeven quantity of sales? what is the formula?

Answer 7

amount of quantity that needs to be sold so that you cover your variable and fixed costs.

Qbe = fixed operating costs + fixed financing costs / price - variable cost per unit

Question 8

What is the formula for operating breakeven quantity of sales?

Answer 8

Qbe = fixed operating costs / price - variable cost per unit

Question 9

What is the relationship between operating leverage and breakeven quantities?

Answer 9

higher operating leverage will result in greater breakeven quantity.