Financial leverage

Financial leverage is the relationship between operating profit and EPS (earnings per share). In short, it measures the level of debt. It is a measure of how the potential use of fixed financial costs (e.g. interest on debt) can enlarge the effect that change in operating profit (EBIT) has on EPS (earnings per share).

When does a firm have financial leverage?

If a firm has mixed financial costs, it has financial leverage. Due to financial leverage (existence of fixed financial costs), any increase in EBIT will result in even larger increases in EPS and any decrease in EBIT will result in even larger decreases in EPS.

How to calculate degree of financial leverage (DFL) of the firm?

To calculate degree of financial leverage, which is just a way to measure financial leverage of the firm, we can follow the following formula:

DFL =% change in EPS/% change in EBIT

Therefore, if the degree of financial leverage is greater than 1, then financial leverage exists (which is the case as long as the company has fixed financial costs). Also, any increase in financial leverage results in an increase in risk and any decrease in financial leverage results in a decrease in risk.

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Operating leverage

Operating leverage is the relationship between sales and revenue (Price*Quantity of units sold) and operating profit (which is also called EBIT (earnings before interest and taxes)). It is a measure of how the potential use of fixed costs can enlarge the effect that change in sales volume has on operating profit (EBIT).

We can represent the calculation of operating leverage as follows:

Sales (P * Q)

Less: Fixed operating costs (FC)

Less: Variable operating costs (VC*Q)

= EBIT

Or

EBIT = (P*Q)-FC-(VC*Q)

This simplifies into:

EBIT = Q * (P-VC) – FC

When do firms have operating leverage?

If a firm has fixed costs, it has operating leverage. Because fixed cost (FC) is unchanged, an increase in sales revenue (P*Q) results in a proportionally bigger increase in EBIT (earnings before interest and taxes, which is also called operating profit). However, decrease in sales revenue (P*Q) will result in a proportionally bigger decrease in EBIT.

Increase in operating leverage increases business risk, which is a chance that the business will not be able to cover its operating costs.

How to calculate the degree of operating leverage (DOL) of the firm?

To calculate degree of operating leverage, which is just a way to measure operating leverage of the firm, we can use the following formula:

DOL =% change in EBIT/% change in sales

Therefore, if the degree of operating leverage is greater than 1, than operating leverage exists (which is the case as long as the company has fixed operating costs).

Businesses can increase their operating leverage by substituting variable costs for fixed costs, where possible. For example, salaries to sales personnel could be fixed instead of variable of units sold. Of course, many other variables need to be taken into account to make such a decision, such as consideration of how such changes would affect motivation levels of sales personnel.

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Leverage

In finance, leverage (which is also called gearing or levering) refers to the use of debt rather than equity as a source of capital to finance investments and reinvestments. The more debt the business uses the more leverage it has.

As leverage increases, the risks also increase and so does the return on investment. However, as leverage decreases, the risks also decrease as well as the return on investment. Management have almost total control over the risk introduced by increased leverage.

There are three types of leverage:

  • Operating leverage – refers to the relationship between sales revenue and operating profit (which is also called EBIT (earnings before interest and taxes))
  • Financial leverage – refers to the relationship between operating profit and EPS (earnings per share)
  • Combined or total leverage – refers to the relationship between sales revenue and EPS

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Degree of total leverage (DTL)

The degree of total leverage, which is a way to measure the total leverage of the firm, refers to the relationship between sales revenue and EPS. It (financial and operating leverage) is a measure of how potential total fixed costs (fixed operating costs and fixed financial costs) can enlarge the effect that change in sales (P*Q) has on EPS (earnings per share).

When does a firm have total leverage?

If the (DTL) is greater than 1, than total leverage exists (which is the case as long as the company has fixed operating or/and financial costs). Due to total leverage (existence of fixed operating or/and financial costs), any increase in sales will result in an even larger increase in EPS and any decrease in sales will result in an even larger decrease in EPS. The higher the fixed financial and operating costs, the higher the (DTL). There are three approaches to calculate the (DTL):

1st approach to calculate the (DTL)


To calculate the (DTL), we can utilize the following formula:

(DTL) =% change in EPS / % change in sales

Test yourself

ABC has a change in operating profit of 70%, change in EPS of 310% and change in sales of 60%.

Required:

Find the degree of operating leverage, the degree of financial leverage and the degree of total leverage.

Solution:

Degree of operating leverage:

DOL =% change in EBIT / % change in sales DOL =70%/60% DOL =1.17

Degree of financial leverage:

DFL =% change in EPS / % change in EBIT DFL =310%/70% DFL =4.43

(DTL):

DTL =% change in EPS / % change in sales DTL =310%/60% DTL =5.17

2nd approach to calculate the (DTL)


If we have data on the degree of operating leverage and degree of financial leverage, then the (DTL) can be calculated as follows:

(DTL) = DOL * DFL

Test yourself:

ABC has a change in operating profit of 70%, change in EPS of 310% and change in sales of 60%.

Required:

Find the (DTL) using the second approach.

Solution:

Firstly, we need to find the degree of operating leverage and the degree of financial leverage.

Degree of operating leverage:

DOL =% change in EBIT / % change in sales DOL =70%/60% DOL =1.17

Degree of financial leverage:

DFL =% change in EPS / % change in EBIT DFL =310%/70% DFL =4.43

Now, we can calculate the degree of total leverage.

(DTL):

DTL=DOL*DFL

DTL=1.17*4.43

DTL=5.18

Note that this is aligned with the answer that we obtained while using 1st approach above for calculation of the degree of total leverage.

3rd approach to calculate the (DTL)


There is another formula that can be used to calculate the (DTL). A third approach to calculate the (DTL) is a more direct technique. The formula is as follows:

(DTL) at base sales level Q =

Q*(P-VC)/Q*(P-VC)-FC-I-(PD*1/1-T)

WHERE:

Q – sale quantity in units

P – sale price per unit

VC – variable operating cost per unit

FC – fixed operating cost per unit

I – interest

PD – preferred stock dividends

T – tax rate

Test yourself:

ABC Corporation ascertained that Q=1800, P=$8, VC=$3, FC=$1300, I=$1,800, PD=$3,000 and the tax rate is 40%.

Required:

Find the (DTL) using a more direct formula for calculation.

Solution:

The calculation of the (DTL) of ABC Corporation will be as follows:

Degree of total leverage at base sales level Q = 1800*(8-3)/1800*(8-3)-1300-1800-(3000*1/1-.4)

Degree of total leverage at base sales level Q = 9000/900

Degree of total leverage at base sales level Q = 10

Since the result is greater than 1, ABC Corporation has total leverage.

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