Operating and financial leverage

OPERATING AND FINANCIAL LEVERAGE

Leverage refers to the use of fixed costs in an attempt to increase (or lever up) profitability. Operating leverage is due to fixed operating costs associated with the production of goods or services, while financial leverage is due to the existence of fixed financing costs—in particular, interest on debt. Both types of leverage affect the level and variability of the firm’s after-tax earnings and, hence, the firm’s overall risk and return.

We can study the relationship between total operating costs and total revenues by using a breakeven chart which shows the relationship among total revenues, total operating costs, and operating profits for various levels of production and sales.

The break-even point is the sales volume required so that total revenues and total costs are equal. It may be expressed in units or in sales dollars.

A quantitative measure of the sensitivity of a firm’s operating profit to a change in the firm’s sales is called the degree of operating leverage (DOL). The DOL of a firm at a particular level of output (or sales) is the percentage change in operating profit over the percentage change in output (or sales) that causes the change in profits. The closer a firm operates to its break-even point the higher is the absolute value of its DOL.

The degree of operating leverage contributes but one component of the overall business risk of the firm. The other principal factors giving rise to business risk are variability or uncertainty of sales and production costs. The firm’s degree of operating leverage magnifies the impact of these other factors on the variability of operating profits.

Financial leverage is the second step in a two-step profit-magnification process. In step one, operating leverage magnifies the effect of changes in sales on changes in operating profit. In step two, financial leverage can be used to further magnify the effect of any resulting changes in operating profit on changes in earnings per share.

Earning before interest and taxes (EBIT)-Earnings per share (EPS) break-even, or indifference analysis is used to study the effect of financing alternatives on earnings per share. The break-even point is the EBIT level where EPS is the same for two (or more) alternatives. The higher the expected level of EBIT, assuming that it exceeds the indifference point, the stronger the case that can be made for debt financing, all other things the same. In addition, the financial manager should assess the likelihood of future EBIT actually falling below the indifference point.

A quantitative measure of the sensitivity of a firm’s earnings per share to a change I the firm’s operating profit is called the degree of financial leverage (DFL). The DFL at a particular level of operating profit is the percentage change in earnings per share over the percentage change in operating profit that causes the change in earnings per share.

Financial risk encompasses both the risk of possible insolvency and the “added� variability in earnings per share that is induced by the use of financial leverage.

When financial leverage is combined with operating leverage, the result is referred to as total (or combined) leverage. A quantitative measure of the total sensitivity of a firm’s earnings per share to a change in the firm’s sales is called the degree of total leverage (DTL). The DTL of a firm at a particular level of output (or sales) is equal to the percentage change in earnings per share over the percentage change in output (or sales) that causes the change in earnings per share.

When trying to determine the appropriate financial leverage for a firm, the cash-flow ability of the firm to service debt should be evaluated. Firm’s debt capacity can be assessed by analyzing coverage ratios ad the probability of cash insolvency under various levels of debt.

Other methods of analyzing the appropriate financing mix for a company include comparing capital structure ratios of other companies having similar business risk, surveying investment analysts and lenders, and evaluating the effect of a financial leverage decision on a firm’s security rating. In deciding on an appropriate capital structure, all these factors should be considered. In addition, certain concepts involving valuation should guide the decision.