B3 - Leverage
Implications of Financial Leverage
1 - A company that issues debt must produce sufficient operating income (EBIT) to cover its fixed interest costs or it risks bankruptcy 2 - Once fixed interest costs are covered, additional EBIT will go straight to net income and earnings per share 3 - A higher degree of financial leverage implies that a relatively small change in earnings before interest and taxes (increase or decrease) will have a greater effect on profits and shareholder value
What type of industries have high operating leverage?
Capital-intensive industries; EG - airlines, manufacturing
What type of industries have low operating leverage?
Labor-intensive industries; EG - accountants, attorneys
What is the rule for calculating degree of operating leverage or degree of financial leverage?
The metric cannot be less than 1; Always put the larger % in the numerator
Leverage
The use of fixed costs to amplify risk assumed and potential return
Formula for Degree of Financial Leverage
= (% change in "earnings per share" or "earnings before tax")/(% change in EBIT) >always put the larger percentage in the numerator
Formula for Degree of Operating Leverage
= (% change in EBIT)/(% change in sales)
Formula for Percentage Change in Operating Income
= (% change in sales) x (degree of operating leverage) >The bigger the degree of operating leverage, the bigger the change in operating income
Formula for Percentage Change in Earnings Per Share
= (change in EBIT) x (degree of financial leverage)
Formula for Degree of Total Leverage
= (degree of operating leverage) x (degree of financial leverage) OR = (% change in EPS)/(% change in sales)
What's an alternate way to calculate the degree of financial leverage?
= assets/equity
What is the implication of having high operating leverage?
The company must produce sufficient sales revenue to cover its high fixed-operating costs; Greater risk, but greater possible returns - beyond the breakeven point, a company with higher fixed costs will retain a higher percentage of additional revenues as operating income
Financial Leverage
The degree to which a company uses debt rather than equity to finance the company; Interest expense is a fixed cost that is independent of sales
Operating Leverage
The degree to which a company uses fixed operating costs rather than variable costs; Total costs that are independent of sales; EG - Depreciation, rent, fixed salaries