Operating and Financial Leverage

Operating Leverage

-Defined as degree to which firm uses fixed operating cost, as opposed to variable costs. -Once the fixed cost are covered the additional cost go straight to the operating income.

High Financial Leverage

-Firms with higher percentage of fixed financing cost will have a higher degree of financial leverage. - The higher degree of financial leverage implies that a relative small change in earning before interest and taxes will have the greater effect on profits and shareholder value. -The greater its profitability, but also greater the risk.

Financial Leverage Formual

DFL= % change in EPS / % change in EBIT

Financial Leverage

- The degree to which a firm uses fixed debt (bonds and loans) and variable debt (equity) to cover its debt. -Company that issues debt must produce sufficient operating income to cover its fixed interest cost. Once, fixed interest cost are covered, additional EBIT will go to net income and earnings per share.

Degree of Operating leverage Formula

% change in EBIT / % change in sales

High Operating Leverage

- Higher % of fixed cost relative to the variable cost - Small changes in the sales will have greater effect on profits and shareholder value. -Leads to greater profitability and greater the risk

Low Operating Leverage

- Lower % of fixed cost relative to the variable cost - Big changes in sales is needed to have greater effects on profit and shareholder value. -Leads to lower profitability and lower risk