Chapter 5

Operating and
Financial
Leverage

Chapter 5 - Outline
What is Leverage?
Break-Even (BE) Point
Operating Leverage
Financial Leverage
Leverage Means Risk
Combined or Total Leverage

What is Leverage?
Use of special forces and effects to magnify

or produce more than the normal results from

a given course of action
Leverage involves using fixed costs to

magnify the potential return to a firm

Can produce beneficial results in favorable

conditions
Can produce highly negative results in
unfavorable conditions

Leverage in a Business
Determining type of fixed operational costs

Plant and equipment

Can reduce expensive labor in production of inventory
Expensive labor
Lessens opportunity for profit but reduces risk exposure

Determining type of fixed financial costs

Debt financing
Can produce substantial profits, but failure to meet
contractual obligations can result in bankruptcy
Selling equity
May reduce potential profits for existing shareholders, but
reduces their risk exposure

Break-Even (BE) Point

Quantity where Total Revenue

equals Total Cost

Company has no Profit or Loss
BE = FC / (P VC)
A leveraged firm has a high BE
point
A non-leveraged firm has a low BE
point

FIGURE 5-1
Break-even chart:
Leveraged firm

FIGURE 5-2
Break-even chart:
Conservative firm

TABLE 5-2
Volume-cost-profit analysis:
Leveraged firm

TABLE 5-3
Volume-cost-profit analysis:
Conservative firm

FIGURE 5-3
Nonlinear break-even
analysis

Operating Leverage
Measure of the amount of fixed operating

costs used by a firm.

Degree of Operating Leverage (DOL) = %
in EBIT (or Operating Income) / % in Sales
DOL = Q(P-VC) / (Q(P-VC) FC)
Operating Leverage measures the

sensitivity of a firms operating income to a

in sales.

TABLE 5-4
Operating income or
loss

Financial Leverage
Measure of the amount of debt used by a

firm
Degree of Financial Leverage (DFL) = %
in EPS / % in EBIT (or Operating Income)
DFL = EBIT / (EBIT I)
Financial Leverage measures the

sensitivity of a firms earnings per share to

a in operating income

Leverage Means Risk

Leverage is a double-edged sword
It magnifies profits as well as losses
An aggressive or highly leveraged firm has

high fixed costs (and a relatively high breakeven point)

A conservative or non-leveraged firm has low
fixed costs (and a relatively low break-even
point)
Many Japanese firms tend to be highly
leveraged

FIGURE 5-4
Financing plans and
earnings per share

TABLE 5-5
Impact of financing
plan on earnings
per share

Financial Leverage
Reflects the amount of debt used in the

capital structure of the firm

Determines how the operation is to be

financed
Determines the performance between two
firms having equal operating capabilities
BALANCE SHEET
Assets
Liabilities and Net
Worth
Operating leverage
Financial leverage

TABLE 5-6
Income statement

Combined or Total Leverage

Represents maximum use of

leverage
Degree of Combined or Total
Leverage (DCL or DTL) = % in
EPS / % in Sales
DCL= Q(P-VC)/(Q(P-VC)-FC-I)
= (S-TVC) /( S-TVC FC- I)

Short-cut formula:

DCL or DTL = DOL x DFL

TABLE 5-7
Operating and
financial leverage

Combining Operating
and Financial Leverage
Combined leverage: when both leverages

allow a firm to maximize returns

Operating leverage:
Affects the asset structure of the firm
Determines the return from operations
Financial leverage:
Affects the debt-equity mix
Determines how the benefits received will be

allocated