5

Operating and Financial

Leverage
Block, Hirt, and Danielsen
Foundations of Financial Management
17th edition

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 Learning Objectives
• Leverage represents the use of fixed cost items to magnify the
firm’s results.
• Break-even analysis allows the firm to determine the
magnitude of operations necessary to avoid loss.
• Operating leverage indicates the extent to which fixed assets
(plant and equipment) are utilized by the firm.
• Financial leverage shows how much debt the firm employs in
its capital structure.
• Combined leverage takes into account both the use of fixed
assets and debt.
• By increasing leverage, the firm increases its profit potential,
but also its risk of failure.

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 Chapter Opening

• What is leverage?
• Use of special force or effects to produce more
than normal results from a given course of action
• Emphasis on employment of fixed cost items to
magnify returns at high levels of operation
• Can produce beneficial results in favorable
conditions
• Can produce highly negative results in unfavorable
conditions

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 Leverage in a Business

• Determining type of fixed operational costs

• Plant and equipment
• Eliminates labor in production of inventory
• Expensive labor
• Lessens opportunity for profit but reduces risk exposure
• Determining type of financing
• Debt financing
• Substantial profits but failure to meet contractual
obligations can result in bankruptcy
• Selling equity
• Reduces potential profits but minimizes risk exposure

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 Operating Leverage
• Extent to which fixed assets and associated
fixed costs are utilized in business
• Operational costs are classified
• Fixed
• Variable
• Semivariable

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 Table 5-1 Classification of Costs

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 Figure 5-1 Break-Even Chart: Leveraged Firm

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 Break-Even Analysis

• Break-even point is 50,000 units, where total

costs and total revenue lines intersect

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 Break-Even Analysis Continued
• The break-even point can also be calculated by:

Fixed costs = Fixed costs = FC

Contribution margin Price – Variable cost per unit P – VC

i.e. $60,000 = $60,000 = 50,000 units

$2.00 – $0.80 $1.20

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 Table 5-2 Volume-Cost-Profit
Analysis: Leveraged Firm

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 A More Conservative Approach

• Some firms choose not to operate at high

degrees of operating leverage
• More expensive variable costs may be
substituted for automated plant and equipment
• An unleveraged approach may cut into potential
profitability of firm
• Indicated in Figure 5-2

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 Figure 5-2 Break-Even Chart:
Conservative Firm

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 Table 5-3 Volume-Cost-Profit Analysis:
Conservative Firm

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 The Risk Factor
• Factors influencing decision on maintaining
conservative or leveraged position include
• Economic conditions
• Competitive position within industry
• Future position—stability versus market
leadership
• Matching acceptable returns with desired
level of risk

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 Cash Break-Even Analysis
• Deals with cash flows rather than accounting
flows
• Helps in analyzing short-term outlook of firm
• Examples of excluded noncash items
• Depreciation
• Credit sales
• Credit purchase of materials

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 Degree of Operating Leverage (DOL)
• Percentage change in operating income as
result of percentage change in units sold
• Computed only over profitable range of
operations
• Closer the DOL is to the firm’s break-even
point, the higher the number will be
DOL = Percent change in operating income
Percent change in unit volume

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 Table 5-4 Operating Income or Loss

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 Degree of Operating Leverage (DOL)
Continued
Leveraged firm
DOL = Percent change in operating income = $24,000
Percent change in unit volume $36,000 × 100

20,000
80,000 × 100

= 67% = 2.7
25%
Conservative firm
DOL = Percent change in operating income = $8,000 × 100
Percent change in unit volume $20,000
20,000
80,000 × 100

= 40% = 1.6
25%
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 Degree of Operating Leverage (DOL)
Concluded
Q (P – VC)
DOL =
Q (P – VC) – FC
Where,
• Q = Quantity at which DOL is computed
• P = Price per unit
• VC = Variable costs per unit
• FC = Fixed costs
• For the leveraged firm, assume Q = 80,000, with P = $2, VC = $0.80, and
FC = $60,000:

DOL = 80,000 ($2.00 – $0.80) ;

80,000 ($2.00 – $0.80) – $60,000
= 80,000 ($1.20) = $96,000 ;
80,000 ($1.20) – $60,000 $96,000 – $60,000
DOL = 2.7

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 Limitations of Analysis
• Assumes existence of constant or linear
function for revenues and costs as volume
changes
• May not be constant in the real world
• Price weakening to capture increasing market
• Cost overruns when moved beyond optimum-size
operation
• Relationships are not so fixed as assumed

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 Figure 5-3 Nonlinear
Break-Even Analysis
• Assumption of exact linear relationship does not hold well in
reality

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 Financial Leverage

• Reflects amount of debt used in capital

structure of firm
• Determines how to finance operation
• Determines performance between two firms
with equal operating capabilities
BALANCE SHEET
Assets Liabilities and Net Worth
Operating Leverage Financial Leverage

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 Impact on Earnings

• Examine two financial plans for firm where

$200,000 is required to carry assets

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 Table 5-5 Impact of Financing
Plan on Earnings per Share

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 Figure 5-4 Financing Plans
and Earnings per Share

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 Degree of Financial Leverage
Percent change in EPS
DFL = Percent change in EBIT

• For the purpose of computation, it can be restated as:

EBIT .
DFL = EBIT – I
• DFL can be calculated using values from Table 5-5

Plan A (Leveraged):
EBIT = $36,000 = $36,000 = 1.5
DFL = EBIT – I $36,000 – $12,000 $24,000

Plan B (Conservative):
EBIT = $36,000 __ = $36,000 = 1.1
DFL = EBIT – I $36,000 – $4,000 $32,000

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 Limitations to Use of
Financial Leverage
• Beyond a certain point, debt financing is
detrimental to a firm
• Lenders will perceive greater financial risk
• Common stockholders may drive down price
• Debt is beneficial and recommended for firms
• In industries that offer degree of stability
• Are in a positive stage of growth
• Operating in favorable economic conditions

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 Combining Operating
and Financial Leverage
• Combining operating and financial leverage
allows firms to maximize returns
• Operating leverage
• Affects asset structure of firm
• Determines return from operations
• Financial leverage
• Affects debt-equity mix
• Determines how benefits received are allocated to debt
holders and stockholders as earnings per share

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 Table 5-6 Income Statement

• Last item under operating leverage, operating income, becomes

initial item for determining financial leverage
• “Operating income” and “Earnings before interest and taxes” are
the same, representing return to owners before interest and
taxes are paid
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 Figure 5-5 Combining Operating
and Financial Leverage

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 Table 5-7 Operating and
Financial Leverage

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 Degree of Combined Leverage (DCL)
• Uses the entire income statement
• Shows impact of change in sales or volume on
bottom-line earnings per share

Percent change in EPS ;

DCL = Percent change in sales (or volume)

Using data from Table 5-7:

$1.50
Percent change in EPS = $1.50 × 100 = 100% = 4

Percent change in sales $40,000 × 10025%

$160,000

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 Degree of Combined Leverage (DCL)
Continued
Q (P – VC) ,
DCL =
Q (P – VC) – FC – I
From Table 5-7, Q (Quantity) = 80,000; P (Price per unit) = $2.00;
VC (Variable costs per unit) = $0.80; FC (Fixed costs) = $60,000;
and I (Interest) = $12,000.

80,000 ($2.00 – $0.80) =

DCL =
80,000 ($2.00 – $0.80) – $60,000 – $12,000
= 80,000 ($1.20) =
80,000 ($1.20) – $72,000
$96,000 = $96,000 = 4
DCL = $96,000 – $72,000 $24,000

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