Reading 37 LOS's Flashcards
LOS 37a: Define and explain leverage, business risk, sales risk, operating risk, and financial risk, and classify a risk, given a description
LOS 37b: Calculate and interpret the degree of operating leverage, the degree of financial leverage, and the degree of total leverage
LOS 37c: Analyze the effect of financial leverage on a company’s net income and return on equity
Leverage refers to a company’s use of fixed costs in conducting business. Fixed costs include:
- Operating costs
- Financial costs
Fixed costs are referred to as leverage because they support the company’s activities and earnings. Its important to understand a company’s use of leverage for the following reasons:
- Leverage increases the volatility of a company’s earnings and cash flows, thereby increasing the risk borne by investors in the company
- The more significant the use of leverage by the company, the more risky it is and therefore, the higher the discount rate that must be used to value the company
- A company that is highly leveraged risks significant losses during economic downturns
Business Risk
refers to the risk associated with a company’s operating earnings. operating earnings are risky because total revenues and cost of sales are both uncertain. Therefore business risk can be broken down into sales risk and operating risk
- Sales risk- the uncertainty associated with total revenue is referred to as sales risk
- Operating risk- the risk associated with a company’s operating cost stucture is referred to as operating risk.
A company that has greater proportion of fixed costs relative to variable costs in its cost structure will find it more difficult to adjust its operating costs to changes in sales, and is therefore more risky. In order to examine a company’s sensitivity of operating income to changes in units of sales, we use the degree of operating leverage (DOL)
- DOL = %change in operating income / % change in units sold.
The DOL can also be expressed in terms of its basic elements:
- DOL = Qx (P - V) / Q x ( P - V) - F
where:
- Q= number of units sold
- P = Price per unit
- V= Variable operating cost per unit
- F = Fixed operating cost
DOL is different at different levels of sales. If the company is making operating profits, the sensitivity of operating income to changes in units sold decreases at higher sales volumes.
Financial Risk
Financial Risk refers to the risk associated with how a company chooses to finance its operations. If a company chooses to issue debt or acquire assets on leases, it is obligated to make regular payments, therefore these are fixed obligations. On the other hand if it issues shares or uses retained earnings, the company does not incur fixed obligations. Therefore the higher the amount of fixed financial costs taken on by a company, the greater its financial risk.
Financial risk can be measured as the sensitivity of cash flows available to owners to changes in operating income, know as degree of financial leverage (DFL).
- DFL = % change in net income / % change in operating income
DFL can be simplified into its basic elements:
- DFL = [Q(P-V) - F] (1-t) / Q (P-V) -F-F
where:
- Q= number of units sold
- P= price per unit
- V= variable operating cost per unit
- F= Fixed operating cost
- C = fixed financial cost
- t = tax rate
These calculations verify that the higher the use of fixed financing sources by a company, the greater the sensitivity to net income changes in operating income and therefore the higher the financial risk of the company
The degree of financial leverage is usually determined by the company’s management.
Total Leverage
The degree of total leverage (DTL) looks at the combined effect of opertang and financia. It is calculated as:
- DTL = % change in net income / % change in number of units sold
- DTL = DOL x DFL
- DTL = Q x (P - V) / [Q(P-V) -F-C]
LOS 37d: calculate the breakeven quantity of sales and determine the company’s net income at various sales levels
LOS 37e: Calculate and interpret the operating breakeven quantity of sales
Breakeven points and Operating Breakeven points
A company’s breakeven point occurs at the number of units produced and sold at which its net income equals zero (revenues equal costs). This occurs when:
- PQ = VQ + F + C
where:
- P= Price per unit
- Q = Number of units produced and sold
- V = variable cost per unit
- F = Fixed operating costs
- C = Fixed financial cost
The breakeven number of units can be calculated as:
- QBE= (F + C) / (P-V)
A breakeven point can also be specified in terms of operating profit, in which case it is known as the operating breakeven point. At this point revenues equal operating costs. The expression for operating breakeven point is given as:
- PQ = VQ + F
- Q = F / P-V
