Measures of Leverage

Leverage, Business Risk, and Financial Risk

Operating leverage arises when a firm has fixed operating costs in its income stream. The presence of operating leverage magnifies the effects of changes in sales to the firm’s operating earnings, i.e., a change in the volume of sales results in a “more than proportional” change in operating profit (or loss).

The <b>degree of operating leverage</b> is a leverage ratio that measures how a percentage change in sales volume will affect the firm’s operating profits (<a title="How to Calculate Earnings Before Interest and Tax (EBIT)" href="https://financetrain.com/how-to-calculate-earnings-before-interest-and-tax-ebit/">EBIT</a>), at a certain level of sales.

<img class="aligncenter size-full wp-image-15660" alt="DOL" src="https://financetrain.com/wp-content/uploads/dol1.gif" width="524" height="59" />

We can calculate the DOL of a company at a particular level of sales as follows:

<img class="aligncenter size-full wp-image-15659" alt="DOL" src="https://financetrain.com/wp-content/uploads/dol2.gif" width="505" height="132" />

Where:
<ul>
	<li>Q is the quantity of sales</li>
	<li>P is the price per unit</li>
	<li>VC is the variable cost</li>
	<li>FC is the fixed cost</li>
	<li>S is Sales</li>
	<li>TVC is total variable cost</li>
</ul>
<h3><span style="font-size: 0.83em;">Example</span></h3>
Annie Davis wants to determine the degree of operating leverage at sales levels of 6,000 and 8,000 units.  Assume that:

Fixed costs are $100,000

Baskets are sold for $40 each

Variable costs are $15 per basket

DOL at 6000 units:

<img class="aligncenter size-full wp-image-15658" alt="dol3" src="https://financetrain.com/wp-content/uploads/dol3.gif" width="454" height="61" />

DOL at 8000 units:

<img class="aligncenter size-full wp-image-15657" alt="dol4" src="https://financetrain.com/wp-content/uploads/dol4.gif" width="447" height="60" />

DOL is interpreted as follows: A 1% increase in sales above the 8,000 unit level increases EBIT by 2% because of the existing operating leverage of the firm.

Also observe that DOL is higher at lower level of sales and it declines as sales increase.

How to Calculate Degree of Operating Leverage

Financial leverage arises when a firm has fixed financing costs in its income stream. The presence of financial leverage magnifies the effects of changes in sales to the firm’s net earnings. Sources of financial leverage are primarily debt and <a title="Preference Shares – Meaning, Types and Features" href="https://financetrain.com/preference-shares-meaning-types-features/">preferred stock</a>. The British expression for financial leverage is gearing.

The <b>degree of financial leverage</b> is a leverage ratio that measures the percentage change in a firm’s <a title="How to Calculate Basic Earnings Per Share (EPS)" href="https://financetrain.com/how-to-calculate-basic-earnings-per-share-eps/">earnings per share (EPS)</a> resulting from a 1% change in operating profit.

<img class="aligncenter size-full wp-image-15665" alt="DFL" src="https://financetrain.com/wp-content/uploads/dfl1.gif" width="467" height="57" />

We can calculate the DFL of a company at a particular level of operating earnings as follows:

<img class="aligncenter size-full wp-image-15664" alt="dfl2" src="https://financetrain.com/wp-content/uploads/dfl2.gif" width="432" height="57" />

Annie Davis wants to determine the degree of financial leverage at earnings level of $500,000. Assuming that the interest expense is $100,000, the degree of financial leverage will be calculated as follows:

<img class="aligncenter size-full wp-image-15663" alt="DFL" src="https://financetrain.com/wp-content/uploads/dfl3.gif" width="436" height="61" />

If debt increases 1%, the earnings per share will increase by 1.25%.

Note that as the fixed financing costs increase, the DFL will increase. DFL will be equal to 1 when there is no fixed financing cost. For both DFL and DOL, a value of 1 means that there is no leverage.

Degree of Financial Leverage

Using the formulas for <a title="How to Calculate Degree of Operating Leverage" href="https://financetrain.com/calculate-degree-operating-leverage/">Degree of Operating Leverage (DOL)</a> and <a title="Degree of Financial Leverage" href="https://financetrain.com/degree-financial-leverage/">Degree of Financial Leverage (DFL)</a>, we can calculate the degree of total leverage (DTL) for the firm as follows:

<img class="aligncenter size-full wp-image-15670" alt="Degree of Total Leverage" src="https://financetrain.com/wp-content/uploads/dtl.gif" width="490" height="235" />

In the above formula, you can observe that if there are no fixed operating costs and fixed financing costs, there is no leverage, and DTL will be equal to 1.

COURSE

Measures of Leverage

Course Resources

Course Quizzes

Lessons

R Programming Bundle: 25% OFF

Course Resources

Course Quizzes