5
Operating
and Financial
Leverage
Prepared by:
Michel Paquet
SAIT Polytechnic
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©2009 McGraw-Hill Ryerson Limited
Chapter 5 - Outline
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What is Leverage?
Break-Even Analysis
Operating Leverage
Risk Analysis of Leverage
Financial Leverage
Indifference Point
Combined or Total Leverage
Summary and Conclusions
©2009 McGraw-Hill Ryerson Limited
Learning Objectives
1. Define leverage as a method to magnify
earnings available to the firm’s common
shareholders. (LO1)
2. Define and calculate operating leverage
and assess its opportunities and
limitations. (LO2)
3. Define and calculate financial leverage
and assess its opportunities and
limitations. (LO3)
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Learning Objectives
4. Calculate the indifference point between
financing plans using EBIT/EPS analysis.
(LO4)
5. Define and calculate combined leverage.
(LO5)
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LO1
What is Leverage?
Leverage is using fixed costs to magnify
the potential return to a firm
2 types of fixed costs:
1. fixed operating costs = rent, amortization
2. fixed financial costs = interest costs from debt
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LO1
What is Leverage?
2 types of leverage:
1.
2.
Operating Leverage = the extent to which capital assets and associated
fixed costs are utilized
Financial Leverage = the amount of debt used in the capital structure
(debt/equity mix)
Balance Sheet___________________
Assets
Liabilities and Equity
Current Assets
Debt (Loans, bonds, leases)
Operating
(interest charges) Financial
Leverage Capital Assets
Equity (Shares) Leverage
(fixed charges)
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LO1
Table 5-1
Income statement
Sales (total revenue) (80,000 units @ $2) $160,000
— Variable costs ($0.80 per unit)
64,000
Contribution margin
96,000
— Fixed costs
60,000
Operating income
36,000
Earnings before interest and taxes
36,000
— Interest Expense
12,000
Earnings before taxes
24,000
— Taxes
12,000
Earnings aftertaxes
$ 12,000
Shares
8,000
Earnings per share
$1.50
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Operating
leverage
Financial
leverage
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LO1
Break-Even Analysis
• A firm’s operational costs may be classified
as:
-- fixed: those costs that remain the same in the short
run (e.g.: rental, amortization, executive salaries,
property taxes)
-- variable: those costs that change as
production/sales changes (e.g. raw material,
factory labour, sales commissions)
-- semi variable: those costs that may change but not
directly related to production/sales (e.g. utilities,
repairs and maintenance)
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LO2
Break-Even Analysis
• Break-even analysis is the technique used to study the
effect of sales volume on costs and profit.
• The interesting sales volume is the break-even (BE)
sales level, at which a firm’s total revenue equals total
cost, that is, the firm does not make money nor lose
money (breaks even)
• Mathematically,
Fixed costs
FC
FC
BE 


Contribution margin P  VC CM
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LO2
Table 5-3
Volume-cost-profit analysis: leveraged
firm
Total
Units Variable
Sold
Costs
0
20,000
40,000
50,000
60,000
80,000
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Fixed
Costs
Total
Costs
Operating
Total
Income
Revenue
(loss)
0
16,000
32,000
40,000
48,000
64,000
$60,000
60,000
60,000
60,000
60,000
60,000
$ 60,000
0 $(60,000)
76,000 $ 40,000 (36,000)
92,000
80,000
(12,000)
100,000 100,000
0
108,000 120,000
12,000
124,000 160,000
36,000
100,000 80,000
60,000
140,000
200,000
60,000
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LO2
FIGURE 5-1
Break-even chart:
Leveraged firm
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LO2
Table 5-4
Volume-cost-profit analysis:
conservative firm
Total
Units Variable
Sold
Costs
0
0
20,000 $ 32,000
30,000 48,000
40,000 64,000
60,000 96,000
80,000 128,000
100,000 160,000
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Fixed
Costs
Total
Costs
$12,000 $ 12,000
12,000
12,000
12,000
12,000
12,000
12,000
Operating
Total
Income
Revenue
(loss)
0
$(12,000)
44,000 $ 40,000
60,000
60,000
76,000
80,000
108,000 120,000
140,000 160,000
172,000 200,000
(4,000)
0
4,000
12,000
20,000
28,000
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LO2
FIGURE 5-2
Break-even chart:
Conservative firm
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LO2
Operating Leverage
• Measures the amount of fixed operating costs
used by a firm
• Degree of Operating Leverage (DOL)=
%age  in EBIT ( or OI)
%age  in Sales
• a  in Sales  a larger  in EBIT (or OI) if
DOL > 1
• DOL measures the sensitivity of a firm’s
operating income to a  in sales
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LO2
Risk Analysis of Leverage
• A leveraged firm has high fixed costs,
a high BE point and high DOL.
• A non-leveraged firm has low fixed
costs, a low BE point and low DOL.
• Leverage is a double-edged sword.
It magnifies losses as well as profits.
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LO3
Table 5-5
Operating income or loss
Units
0
20,000
40,000
60,000
80,000
100,000
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.
.
.
.
.
.
.
.
.
.
.
.
.
.
Leveraged
Firm
(Table 5-3)
Conservative
Firm
(Table 5-4)
. $(60,000)
. (36,000)
.
(12,000)
.
. 12,000
. 36,000
. 60,000
$(12,000)
(4,000)
4,000
12,000
20,000
28,000
©2009 McGraw-Hill Ryerson Limited
LO3
FIGURE 5-3
Nonlinear break-even
analysis
Profit
Loss
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LO3
Financial Leverage
• Measure of the amount of debt used by a firm
• Degree of Financial Leverage (DFL) =
%age  in EPS
%age  in EBIT (or OI)
• a  in EBIT (or OI)  a larger  in EPS if
DFL > 1
• DFL measures the sensitivity of a firm’s
earnings per share to a  in operating income.
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LO4
TABLE 5-6
Impact of financing
plan on earnings
per share
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LO4
Indifference Point
• the level of EBIT at which alternative financing plans
yield the same earnings per share (EPS)
• Mathematically,
SB  I A  S A  I B
EBIT * 
SB  S A
(24,000  $12,000)  (8,000  $4,000)
EBIT * 
 $16,000
24,000  8,000
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LO4
FIGURE 5-4
Financing plans and
earnings per share
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LO4
Figure 5-5
Financial leverage in selected industries
Total debt / equity
Long-term debt / equity
3.00
2.50
Ratio
2.00
1.50
1.00
0.50
Al
li
nd
us
Al
tri
ln
es
on
fin
an
ci
al
Ag
ri c
ul
tu
O
re
il
an
d
G
as
M
in
im
g
U
til
itie
C
on
s
st
ru
ct
M
io
an
n
uf
ac
tu
rin
R
g
ea
l
Ac
es
ta
co
te
m
m
od
at
io
n
0.00
Source: Statistics Canada, “Quarterly Financial Statistics for Enterprises”, Catalogue 61-008-X, First quarter, 2008
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LO5
Combined or Total Leverage
• Represents maximum use of leverage
• Degree of Combined Leverage (DCL ) =
%age  in EPS
%age  in Sales
• a  in Sales  a larger  in EPS if DCL > 1
• Short-cut formula:
DCL or DTL = DOL x DFL
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LO5
FIGURE 5-6
Combining
operating
and financial
leverage
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LO5
Table 5-7
Operating and financial leverage
(Taken from Table 5-6)
(80,000 units)
Sales — $2 per unit
— Variable costs ($0.80 per unit)
Contribution margin
— Fixed costs
Operating income (EBIT)
— Interest
Earnings before taxes
— Taxes
Earnings aftertaxes
Shares
Earnings per share
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$160,000
64,000
$96,000
60,000
36,000
12,000
24,000
12,000
$ 12,000
8,000
$1.50
(100,000 units)
$200,000
80,000
$120,000
60,000
60,000
12,000
48,000
24,000
$ 24,000
8,000
$3.00
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LO2/LO3/LO4
Formula Review
Fixed costs
FC
FC
BE 


Contribution margin P  VC CM
CM
DOL 
EBIT
EBIT
DFL 
EBT
EBIT * 
S  I  S  I 
B
A
S S
B
A
B
A
DCL = DOL × DFL
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Summary and Conclusions
• Leverage refers to the use of fixed costs to
magnify the profits (or losses) of a firm
• It is a double-edged sword. Management must
be sure of the level of risk assumed
• Operating leverage refers to using fixed
operating costs, such as lease or amortization
expense
• The degree of operating leverage (DOL)
measures the %age change in operating income
as a result of a %age change in sales
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Summary and Conclusions
• Financial leverage refers to the fixed financing
charge such as interest cost on debt
• The degree of financial leverage (DFL)
measures the %age change in earnings per
share (EPS) as a result of a %age change in
operating income
• The higher the level of fixed costs (both
operating and financing costs), the greater the
effect on net income of an increase in sales
revenue (This is the degree of combined
leverage (DCL))
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