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LEVERAGE ANALYSIS

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LEVERAGE

yResults from the use of fixed-cost assets or

funds to magnify returns to the firmsowners.

y Generally :y Increases in leverage result in increased return and risk

y Decreases in leverage result in decreased return and risk

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LEVERAGEy The amount of leverage in the firms capital structure

can significantly affect its value by affecting return and

risk.y Unlike some causes of risk, management has almost

complete control over the risk introduced through theuse of leverage.

yBecause of its effect in value, the financial managerunderstand how to measure and evaluate leverage,particularly in making capital structure decision.

y **CAPITAL STRUCTURE  the mix of long-term debt and

equity maintained by the firm

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THREE BASIC TYPES

y1. OPERA TING LEVERAGE

y2. FINANCIAL LEVERAGE

y3. TOT AL LEVERAGE

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General Income Statement Format and T ypes of 

Leverage

Sales Revenue

Less: Cost of Goods Sold

Gross Profit

Less: Operating ExpensesEarnings before interest and Taxes (EBIT)

Less: Interest

Net Profits before taxes

Less: Taxes

Net Profits after taxesLess: Preferred stock dividends

Earnings Available for common stockholders

Earnings per share (EPS)

T

o

t

al

L

e

v

e

r 

a

g

e

Operating

Leverage

Financial

Leverage

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Operating Leveragey Is the ratio of a companys level of fixed costs to total

costs at different levels of safety or activity.

y A company has a high operating leverage if its costs isconsists mainly of fixed costs

y FOR EXAMPLE:

y  A capital-intensive plant has a high operating leverage.

 Another company may choose to set up its plant as ahigh labor, low capital plant. Such a company has a lowoperating leverage.

y The use of fixed cost to make operations more efficient

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Operating Leveragey The measure of operating leverage is the degree of 

operating leverage (DOL).

y DOL is the percentage change in profit for each

percentage change in output.y FORMULA:

Degree of Operating = Percentage change in profit

Leverage Percentage change in output

* = Contribution MarginEBIT

= Sales Total Variable Cost

Sales Total Variable Cost Total

Fixed Costs

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y DOL is the counterpart of the concept elasticity in basiceconomics.

y

It measures the responsiveness of profits to a change inthe level of output.

y Since fixed costs does not change with output, DOL willhave values at different volumes of output as follows:

y

(a) positive above the break-even sales volumey (b) negative below the break-even sales volume and;

y (c) zero at zero sales volume

y DOL decreases as the volume of output increases.

Operating Leverage

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Operating Leveragey Illustrative Example:y T wo companies producing identical products for the same

markets have the following costs and sales levels:

 ABC Co. XYZ Co.

Total Variable Costs (P) 500,000 1,200,000

Total Fixed Costs (P) 1,000,000 300,000

Total Sales Volume (units) 10,000 10,000

Total Sales (P) 2,000,000 2,000,000

The management of the two companies would want todetermine their respective degrees of leverage at these saleslevel

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