Financial Analysis: Measures of Leverage

Which of the following statements about capital structure and leverage is most accurate? A) Financial leverage is directly related to operating leverage B) Increasing the corporate tax rate will not affect capital structure decisions. C) A firm with low operating leverage has a small proportion of its total costs in fixed costs.

C) A firm with low operating leverage has a small proportion of its total costs in fixed costs.

Which of the following is a key determinant of operating leverage? A) Level and cost of debt B) The competitive nature of the business C) The trade-off between fixed and variable costs

C) The trade-off between fixed and variable costs. The extent to which costs are fixed determines operating leverage.

If there are no interest costs

DFL is equal to one.

If there are no fixed costs

DOL is equal to one.

In the leveraged scenario

ROE is more volatile compared to EBIT.

DOL is highest

at low levels of sales and declines at higher levels of sales.

Fixed Operating expenses

building or equipment leases.

Net income at various levels

can be calculated as total revenue (price*quantity sold) minus total costs (i.e., total fixed costs plus total variable costs).

degree of total leverage (DTL)

combines the degree of operating leverage and financial leverage. It measures the sensitivity of EPS to change in sales.

operating breakeven quantity of sales

consider only fixed operating costs and ignore fixed financing costs

F

fixed costs

leverage

increases the risk an potential return of a firm's earnings and cash flows.

financial leverage

increases with fixed financing costs.

operating leverage

increases with fixed operating costs.

Fixed Financial Costs

interest payments on debt.

degree of financial leverage (DFL)

interpreted as the ratio of the percentage change in net income (or EPS) to the percentage change in EBIT.

The degree of operating leverage (DOL)

is defined as the percentage change in operating income (EBIT) that results from a given percentage change in sales.

Greater leverage

leads to greater variability of the firm's after-tax operating earnings and net income.

Financial leverage increases the

level of ROE and the rate of change for ROE

EBIT

operating income-- Earnings before interest & tax

Business risk is the combination of

operating risk and sales risk.

P

price per unit

Q

quantity of units sold

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.

Financial risk

refers to the additional risk that the firm's common stockholders must bear when a firm uses fixed cost (debt) financing.

Operating risk

refers to the additional uncertainty about operating earnings caused by fixed operating costs. The greater the proportion of fixed costs to variable costs, the greater a firm's operating risk.

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.

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.

S

sales

The use of financial leverage

significantly increase the risk and potential rewards to common stockholders.

Leverage *British refer to it as "gearing"

the amount of fixed costs a firm has.

The breakeven quantity of sales

the amount of sales necessary to produce a net income of zero (total revenue just covers total costs)

The operating breakeven quantity of sales is

the amount of sales necessary to produce an operating income of zero (total revenue just covers total operating costs)

The degree of total leverage (DTL)

the combination of operating and financial leverage and is calculated as DOL*DFL

Contribution Margin

the difference between price and variable cost per unit

the further a firm's sales are from its breakeven level of sales...

the greater the magnifying effects of leverage on net income.

breakeven quantity

the level of sales that a firm must generate to cover all of its fixed and variable costs is called the breakeven quantity.

breakeven quantity of sales

the quantity of sales for which revenues equal total costs, so that net income is zero.

Business risk

the risk associated with the firm's operating income and is the result of uncertainty about a firm's revenues and the expenditures necessary to produce those revenues. Business risk is the combination of sales risk and operating risk.

The use of financial leverage increases

the risk of default, but also increases the potential return for equity holders.

Sales risk

the uncertainty about the firm's sales.

If there are no fixed costs

there is no operating leverage.

TVC

total variable costs

V

variable cost per unit

ROE & EBIT

vary directly; if one increases the other does too, same for decrease.