LOS 37 - CF - Measures of Leverage

LOS 37.e: Calculate and interpret the operating break-even quantity of sales.

The operating break-even quantity of sales is the amount of sales necessary to produce an operating income of zero (total revenue just covers total operating costs) and can be calculated as: fixed operating costs / price - variable cost per unit

LOS 37.a: Define and explain leverage, business risk, sales risk, operating risk, and financial risk and classify a risk.

Leverage increases the risk and potential return of a firm's earnings and cash flows. Operating leverage increases with fixed operating costs. Financial leverage increases with fixed financing costs. Sales risk is uncertainty about the firm's sales. Business risk refers to the uncertainty about operating earnings (EBIT) and results from variability in sales and expenses. Business risk is magnified by operating leverage. Financial risk refers to the additional variability of EPS compared to EBIT. Financial risk increases with greater use of fixed cost financing (debt) in a company's capital structure.

LOS 37.d: Calculate the breakeven quantity of sales and determine the company's net income at various sales levels.

The breakeven quantity of sales is the amount of sales necessary to produce a net income of zero (total revenue just covers total costs) and can be calculated as: = Fixed operating costs + Fixed Financing costs _____________________________ price - variable cost per unit Net income at various sales levels can be calculated as total revenue (i.e., price × quantity sold) minus total costs (i.e., total fixed costs plus total variable costs).

LOS 37.b: Calculate and interpret the degree of operating leverage, the degree of financial leverage, and the degree of total leverage.

The degree of operating leverage (DOL) is calculated as: DOL = Q(P-V) / Q(P-V) - F Interpreted as: %ChangeEbit / %ChangeinSales The degree of financial leverage (DFL) is calculated as Ebit / Ebit - 1 interpreted as: %ChangeEPS / %ChangeEbit The degree of total leverage (DTL) is the combination of operating and financial leverage and is calculated as: DOL × DFL interpreted as: %ChangeEPS / %ChangeSales

LOS 37.c: Analyze the effect of financial leverage on a company's net income and return on equity.

Using more debt and less equity in a firm's capital structure reduces net income through added interest expense but also reduces net equity. The net effect can be to either increase or decrease ROE.