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20
LEVERAGE AS RISK
Introduction
Risk Recalled
- Business Risk
- Operating Risk
- Financial Risk
Structural Leverage
- Operating Leverage
- Financial Leverage
- Combined Leverage
Restructuring
Summary
Introduction
With a good understanding of accounting - used for external reporting and for
internal management - as well as finance - used for investing and financing
decisions - the financial manager maintains control of the financial ‘strings’ of the
company. The nature of a business is that the internal environment is controlled to
provide, as far as possible, a good platform from which to deal with the external
environment. The sales force is directed to maximise the level of sales, the
production process is controlled to enable the proper quality product to be
produced, the service department is controlled in order to provide good customer
relations.
In the interests of control, the financial manager must determine the financial
movements of the firm in order for there to be appropriate levels of debt and equity.
For example, sufficient monies must be available for seasonal working capital
needs, investment decisions must recognise profitability. Organisational systems
providing internal controls, external reports, investment analysis and financing
information can lead one to believe that achieving a proper mix and appropriate
control is possible.
If this were true then there would be some ideal level of debt for the firm and there
would also be some ideal level of fixed costs and variable costs. Control of these
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Financial Management and Decision Making
two financial aspects of the firm have a major impact on profitability. The goal of
maximising shareholders’ wealth requires that these issues be considered when
managing the finances of a company.
Yet the achievement of a proper balance between financial and operating leverage
can only take place following consideration of risk. Risk can take many forms. The
external environment has changing needs, tastes, demands, regulations, interest
rates and so forth. This chapter reviews risk as seen specifically from a financial
point of view, and operating and financial leverage are discussed. The extent to
which management can control these types of risk is also examined.
Risk Recalled
Risk has been formally defined as the measure of the variability of returns,
calculated by the standard deviation of the returns. If a company’s earnings before
interest and taxes (EBIT) never vary by more than 3% from one year to the next, it
would be considered less risky by definition, than a company whose EBIT varied
by as much as 25% from year to year. This definition of risk is, however, too
restricted in scope and can be better seen as having three major components business risk, operating risk and financial risk.
Business
Risk
This is often defined as the variability of EBIT. Given the strict definition of risk as
the variability of returns, this is correct. However, the concept of business risk
extends beyond the purely financial dimensions of the business. While EBIT
measures the returns from company operations, those returns vary as a result of
many external and internal elements. Some external causes that may affect EBIT
include a shrinking (or increasing) market demand for the product, an increase
(decrease) in the number and quality of the competitors, and changes in government
regulation. Factors within the internal cost structure of the firm that will impact on
EBIT include cost of goods sold, variable and direct labour, variable and direct
overheads. In other words, the internal influences on EBIT are more within the
control of the firm than external influences. Therefore, business risk is considered
to be not solely the variability of EBIT, but also the risk of various influences
within the firm’s internal cost structure as well as the changing elements in the
particular business’external environment.
Operating
Risk
This is part of the internal cost structure of the firm. The earlier discussion of
Cost-Volume-Profit illustrated that any two firms in the same business, that is,
operating in the same external environment, can have totally different levels of
fixed costs. In order to break even, the fixed costs must be covered by a
contribution margin. Two firms operating in the same external environment having
different fixed costs will then have different EBITs for the same sales level.
Generally, the firm with high fixed costs will require a higher sales level to
breakeven - implying higher operating risk - than the firm with lower fixed costs.
The relationship between fixed costs, variable costs and the sales price the market
will permit, all directly affect the variability of EBIT for the firm. The financial
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manager must understand that the internal cost structure of the firm brings with it an
associated level of operating risk that is only altered when the level of fixed costs or
the sales price (which is often set by the market place) changes.
Financial
Risk
Financial risk refers to the amount of the firm’s assets financed by debt as opposed
to equity. Earlier discussion has shown that the return on shareholders’ funds
(equity) is the same as the return on total assets when the firm is completely or
100% financed by equity. As the firm incurs some debt, the return on equity
increases. However, having a significant amount of debt subjects the shareholder to
the risk of having to pay all of EBIT out in interest expense. The return on equity
(ROE) can be determined by multiplying the return on assets (ROA) by
assets/equity, called the financial leverage multiplier (FLM).
For example, two identical companies achieve identical returns on assets over time.
If firm A has a high FLM while firm B has a low FLM, the resulting ROEs of firm
A will be much more variable than the ROEs of firm B. Increased variability - or
risk - of the ROE due to the financial structure of the firm is called financial risk.
Structural Leverage
When managing the risk profile of a company, business risk, operating risk and
financial risk must all be considered. Control of business risk involves dealing with
both the external environment and the internal cost structure. Operating risk is
largely determined when a level of fixed costs is agreed upon. Financial risk can
only be changed by adjusting the amounts of debt and equity being used in
financing the firm’s assets. It becomes clear that the task of risk control must take a
longer term view rather than shorter term since changes in external environmental
factors, the cost structure, fixed costs and FLM, all happen slowly. Once
established and understood, these factors which make up the risk profile of the
company do not leave the financial manager with ready tools to change them,
particularly in the short term. These elements of the firm’s risk profile therefore
become part of the structural leverage of the firm. The causes and effects of
operating and financial leverage are discussed below.
Operating
Leverage
Operating leverage is the percentage change in EBIT as a result of a percentage
change in sales volume. All of the assumptions of the cost- volume-profit
relationships are made. Specifically, it is assumed that fixed costs remain constant
within the relevant range of sales levels. Therefore, looking at a degree of operating
leverage (DOL) we are assuming a base level of sales as a starting point. In this
way we can relate relative amounts of leverage across different firms or in different
branches or divisions. This measure of leverage can also be used to analyze various
fixed cost levels for operations.
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Financial Management and Decision Making
Example
Joe’s Super Widgits (JSW) present and predicted Income Statements are:
Present
Predicted
(base level)
Sales (at $4/unit)
$400,000
$480,000
Variable Costs (at $2.50/unit)
250,000
300,000
Revenue before Fixed Costs
150,000
180,000
Fixed Costs
120,000
120,000
EBIT
$ 30,000
$ 60,000
To determine JSW’s degree of operating leverage at the base sales level of
$400,000 we need to calculate the percentage change in EBIT and divide that result
by the percentage change in sales. This will measure how much EBIT changes
(expressed as a percentage) in relation to sales changes (also expressed as a
percentage).
Percentage change in EBIT
=
=
Percentage change in sales
=
=
$60,000 - $30,000
$30,000
1 or 100%
$480,000 - $400,000
$400,000
.2 or 20%
Thus, the DOL at this base sales level is:
100% or 5
20%
Knowing the DOL, it is possible to predict EBIT for any change in sales level from
the base level.
Example
JSW’s sales actually drop by 10% in the coming period. The resulting drop in
EBIT will be 5 x 10% or 50%. This is checked by calculating JSW’s Income
Statement for the new sales level.
Sales
Variable costs
Revenue before Fixed Costs
Fixed Costs
EBIT
$360,000
225,000
135,000
120,000
$ 15,000
The $15,000 of EBIT is indeed 50% of the EBIT at the base level of sales.
At the same time, a percentage change in sales times the DOL will yield the
resulting percentage change in EBIT.
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This method of determining the DOL requires that two comparative financial
statements be used, but there are two alternative formulae for DOL which do not.
Each of these formulae is algebraically derived from the original.
(i)
DOL =
Quantity x (Sales Price - Variable Cost)
Quantity x (Sales Price - Variable Cost) - Fixed Cost
For JSW, we can use this formula to find the DOL:
DOL =
100,000 x ($4.00 - $2.50)
100,000 x ($4.00 - $2.50) - $120,000
= $150,000 or 5
$30,000
Alternatively, having only an Income Statement that separates fixed from variable
costs, DOL can be calculated as:
(ii) DOL = Revenue before Fixed Costs
EBIT
and for JSW this gives:
DOL = $150,000 or 5
$30,000
When considering the acquisition of a large machine, a new building or any
purchase which will alter the firm’s fixed costs, the implications of the resulting
operating risk due to operating leverage must be considered.
Financial
Leverage
Operating leverage relates a percentage change in sales to a percentage change in
EBIT. On the other hand, financial leverage is the percentage change in earnings
per share (EPS) as a result of a percentage change in EBIT. Financial leverage is
therefore linked to a base level of EBIT. The degree of financial leverage (DFL) is:
DFL =
Example
Percentage change in EPS
Percentage change in EBIT
JSW now wonders how much of the firm should be financed by debt. Assume JSW
has $250,000 in total assets and a 45% tax rate. The base sales level of $400,000
resulting in EBIT of $30,000 is known. Three options can be considered.
Option 1
Option 2
Option 3
- no debt, 2,500 shares
- $50,000 debt at 10% interest, 2,000 shares
- $125,000 debt at 10% interest, 1,250 shares
In each of these cases a share is worth $100.
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Financial Management and Decision Making
Completing the Income Statements for JSW at the base level of sales and EBIT for
each of these options gives:
EBIT
Interest expense
Earnings Before Tax
Tax at 45%
Earnings After Tax
Total shares
Earnings per share
Option 1
30,000
0
30,000
13,500
16,500
2,500
$6.60
Option 2
30,000
5,000
25,000
11,250
13,750
2,000
$6.875
Option 3
30,000
12,500
17,500
7,875
9,625
1,250
$7.70
Now completing the Income Statements for JSW at the proposed new sales level of
$480,000 with an EBIT of $60,000 gives:
EBIT
Interest expense
Earnings Before Tax
Tax at 45%
Earnings After Tax
Total shares
Earnings per share
Option 1
60,000
0
60,000
27,000
33,000
2,500
$13.20
Option 2
60,000
5,000
55,000
24,750
30,250
2,000
$15.125
Option 3
60,000
12,500
47,500
21,375
26,125
1,250
$20.90
Using the EBIT of $30,000 as the base, the degree of financial leverage is:
DFL $30,000
=
% change in EPS
% change in EBIT
Option 1 DFL =
(13.20 - 6.60)/6.60
(60,000 - 30,000)/30,000
= 100% or 1
100%
Option 2 DFL =
(15.125 - 6.875)/6.875
(60,000 - 30,000)/30,000
= 120% or 1.2
100%
Option 3 DFL =
(20.90 - 7.70)/7.70
(60,000 - 30,000)/30,000
= 171% or 1.71
100%
If we can assume that there is a constant tax rate, then an algebraically equivalent
formula for calculating the DFL is:
DFL
=
EBIT
EBIT - Interest Expense
Checking this formula in the JSW example:
Option 1
$30,000
$30,000 - 0
= 1
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Chapter 20: Leverage as Risk
Option 2
$30,000
$30,000 - $5,000
= 1.2
Option 3
$30,000
$30,000 - $12,500
= 1.71
417
We now know how much EPS will change, expressed as a percentage, for a given
change in EBIT for each of the three financing plans. If option 2 is chosen, and if
EBIT then drops by 40%, this would mean that EPS would drop by 48% (1.2 x
40%).
Combined
Leverage
Operating leverage relates a percentage change in sales to a percentage change in
EBIT. Financial leverage relates a percentage change in EBIT to a percentage
change in EPS. Combined leverage then, is the percentage change in EPS that
results from a percentage change in sales.
% Change in Sales x DOL
% Change in EBIT x DFL
= % Change in EBIT
= % Change in EPS
Therefore:
% Change in Sales x DCL
= % Change in EPS
where DCL = Degree of Combined Leverage.
There are three ways to calculate the degree of combined leverage.
(i)
% change in EPS
% change in Sales
(ii) DCL = DOL x DFL
(iii) DCL =
Quantity x (Sales price - Variable Cost)
Quantity x (Sales price - V.C.) - Fixed Cost - Interest
Example
DCL =
If we assume that JSW chooses to use financing option 2, then what would be the
percentage change in EPS if there was a 20% increase in sales? At the base sales
level of $400,000, EPS in option 2 would be $6.875. At $480,000 in sales, EPS
would be $15.125. Using the above three formulae to determine the DCL gives:
(i)
DCL =
($15.125 - $6.875)/$6.875
= 120% or 6
($480,000 - $400,000)/$400,000
20%
(ii) DCL = 5 x 1.2 or 6
(iii) DCL =
100,000 x ($4.00 - $2.50)
100,000 x ($4.00 - $2.50) - $120,000 - $5,000
= $150,000 or 6
$25,000
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Financial Management and Decision Making
Knowing the DCL, a change in EPS can be projected given a particular change in
sales. For example, JSW sales drop by 15% instead of rising by 20% resulting in
an EPS fall of 90% (-15% x 6).
The combination of fixed costs (operating leverage) and debt (financial leverage)
serves to magnify the variability of returns or risk to the shareholders. If JSW
selects option 3:
DCL = 5 x 1.71 = 8.55
and a 15% drop in sales would then result in a drop in EPS of 128.25% (15 x 8.55).
In other words, JSW shareholders would suffer a considerable loss.
Restructuring
The restructuring of operating leverage is often a byproduct of the capital budgeting
investment decisions in the company. To reduce (increase) fixed costs the entire
firm’s strategic marketing and future planning must be considered. The financial
manager will surely be a participant in these decisions, but will seldom be able to
unilaterally change the fixed cost structure.
Swapping debt for equity, or equity for debt, also involves far-reaching business
policy decisions. If the firm has large amounts of debt, the financial risk is high.
Yet with a high debt level, the company is less likely to be taken over by unwanted
investors. Turning debt into equity is often undertaken when the company
management feels the share price is ‘high’. There is also a need to have contingent
borrowing power for unforeseen investments. If debt levels are already at the
sustainable risk levels, this contingent ability is lost. Thus, it is clear that the
financial manager’s control of financial risk is limited by several other very
important business policy issues and considerations.
Summary
Variability of corporate returns is highlighted by combining operating and financial
leverage in a single measure. It is possible to determine the amount that EBIT will
change for a given change in sales by calculating the degree of operating leverage
(DOL). Having higher fixed costs will increase the DOL, and thus increase the
operating leverage of the firm. The relationship between a change in EBIT and the
resulting change in EPS can be calculated to give the degree of financial leverage
(DFL). The amount of debt being used to carry the company’s assets causes
financial leverage. Large amounts of debt increase the variability of EPS.
It is possible to determine the amount of change that will occur in EPS with a given
change in the level of sales by using the degree of combined leverage (DCL). The
DCL is simply the DOL times the DFL and helps in understanding the causes of
return variability.
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Returning to the question of controlling risk. Business risk has external and internal
causes. It is often beyond the scope of management to control external factors
causing variability in company earnings. Control of the internal effects on
variability can be viewed as controlling fixed costs and interest expense. Yet once a
company is established with a level of fixed costs and a level of debt, changing the
resulting combined leverage is a long term and slow process. For example, if JSW
decided to purchase a new super-duper widget making machine which increases
fixed costs by $50,000 per year, the resulting increase in operating leverage can
only be reduced by selling the machine or lowering other fixed costs. If the firm
financed this new machine by increasing the amount of debt to total assets, then the
resulting increase in financial leverage can only be reduced by reducing debt and
increasing equity.
The process of restructuring fixed and financial costs involves more than just
financial decision making. The overall direction of the firm, its understanding of
how it fits into the market place and where its future lies, will all be factors in
deciding on the ‘proper’ levels of fixed costs, financial costs and ultimately,
business risk.
Glossary of
Key Terms
Business Risk
The variability of earnings before interest and tax (EBIT).
Combined Leverage
The percentage change in earnings per share (EPS) that results from a percentage
change in sales.
Financial Leverage
The percentage change in EPS as a result of a percentage change in EBIT.
Financial Risk
The variability in EPS under different capital structures for a given change in EBIT.
Operating Leverage
The percentage change in EBIT as a result of a percentage change in sales.
Operating Risk
The variability of EBIT under different fixed cost/variable cost combinations, for a
given change in sales.
Selected
Reading
Keown, A.J., Scott, D.F., Martin, J.D., and Petty, J.W., Basic Financial
Management, Third Edition, Prentice-Hall, 1985.
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Financial Management and Decision Making
Questions
20.1
Compare and contrast business risk, operating risk, and financial risk.
20.2
Examine the financial statements of a publicly listed company to determine its structural financial
leverage. What does this amount of leverage imply about its prospects for profitability?
20.3
Alison’s Shirt Manufacturing Company has the following present and predicted Income Statement:
Sales (at $15/shirt)
Variable costs (at $9/shirt)
Revenue Before Fixed Costs
Fixed Costs
EBIT
Interest Expense
Profit Before Tax
Present
$630,000
378,000
252,000
200,000
52,000
45,000
$ 7,000
Predicted
$787,500
472,500
315,000
200,000
115,000
45,000
$ 70,000
Required:
a. Using three different formulae, calculate the degree of operating leverage at the sales level of
$630,000 and show that all three approaches have the same result.
b. Determine the degree of financial leverage.
c. Determine the degree of combined leverage.
d. Explain the significant increase in profits before tax in terms of the operating and financial
structure of the company.
e. What would be the EBIT and Profit Before Tax if sales dropped to $510,000?
20.4
Discuss the risks faced by Alison’s Shirt Manufacturing Company in Question 20.3. Can these risks
be altered and under what circumstances?
20.5
In terms of both units and dollars, what is the breakeven level for Alison’s Shirt Manufacturing
Company in Question 20.3?
20.6
Auckland Boat Builders Ltd has an average selling price of its boats of $600,000. The associated
variable costs are $418,000 per unit. Fixed costs for the firm average $2,000,000 per year.
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Required:
a. How many boats must be sold each year for the firm to break even?
b. What is the degree of operating leverage for a production and sales level of 18 boats?
c. What will be the resulting effect upon earnings before interest and tax if sales drop by 20% from
the volume in (b) above?
20.7
If a firm has a degree of combined leverage of 4.0 and a degree of operating leverage of 1.6, what is
the degree of financial leverage?
20.8
Johnny’s Appleseed Company has developed the following Income Statement. It represents the results
of operations which ended yesterday:
Sales
Variable Costs
Contribution Margin
Fixed Costs
Interest expense
Profit Before Tax
$(000s)
28,000
17,818
10,182
2,000
7,000
1,182
Required:
a. What is the degree of operating leverage?
b. What is the degree of financial leverage?
c. What is the degree of combined leverage?
d. What is the dollar amount of sales needed to break even?
e. How much would profits increase if sales increased by 12%?
20.9
You are given the following information about the Anderson Company:
Per unit selling price
Per unit variable cost
Fixed operating expenses
Interest expense
Tax rate
$2.60
$1.85
$190,000
$18,000
nil
Required:
a. What is the level of sales required for EBIT to equal zero?
b. What is the level of sales required for net income to equal zero?
c. Compute the DOL, DFL and DCL at the following sales levels: 300,000 units, 400,000 units,
1,000,000 units.
d. Discuss the changes you would make to the structure of the company if you had just signed a
contract to sell 1,000,000 units?
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