BEC 3: Leverage

What is Financial Leverage?

It is the degree to which a company uses debt rather than equity to finance the company.

What is operating leverage?

It is the degree to which a company uses fixed operating costs rather than variable operating costs

What is the implication of a company with high operating leverage?

It must produce enough sales revenue to cover its high fixed operating costs. It will have greater risk but greater possible returns.

What is the Degree of Operating Leverage formula?

% Change in Earnings before Income Taxes divided by % change in sales

What is the Degree of Financial Leverage formula?

% Change in Earnings per share divided by % Change in EBIT

What kind of industries have high operating leverage and what kind of industries have low operating leverage?

Capital-Intensive industries have high operating leverage and labor-intensive industries have low operating leverage

What is the implication of a company with high financial leverage?

It must produce enough operating income to cover its fixed interest costs. But the higher degree of financial leverage implies that a small change in earnings before interest and taxes will have a greater effect on profits.

What are the 2 types of leverage?

Operating Leverage and Financial Leverage