B3 : Financial Management (Leverage)

How do you calculate degree of total leverage?

DOL x DFL or % change in earnings per share/ % change in sales

What are the implications of financial leverage?

once fixed interest costs are covered, additional EBIT will go straight to net income and earnings per share a higher degree of financial leverage implies that a relatively small change in EBIT will have a greater effect on profits and shareholder value highly leveraged companies may be at risk of bankruptcy if they are unable to make debt payments

Define leverage.

the use of fixed costs to amplify risk assumed and potential return

Define operating leverage.

things like depreciation and rent, of which the total cost is independent of sales; capital-intensive industries often have high operating leverage while labor-intensive industries have low operating leverage

Define financial leverage.

use of debt (such as interest expense fixed cost) "independent of sales" rather than equity to finance the company

How do you calculate degree of operating leverage?

% change in Earnings before Income Tax/ % change in Sales

How do you calculate degree of financial leverage?

% change in earnings per share (or pre-tax earnings)/ % change in earnings before income tax or Assets/ Equity

What are the implications of operating leverage?

A company with high operating leverage must produce sufficient sales revenue to cover its high fixed-operating costs A company with high operating risk will have greater risk but greater possible returns Beyond the break-even point, a company with higher fixed costs will retain a higher percentage of additional revenues as operating income

What is the rule for calculating DOL and DFL?

Always put larger % in the numerator; must be >/= 1