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