Finance Case

ANALYSIS OF LEVERAGE

The concept of Leverage

When a lever (a bar or other strong tool used for lifting or moving something heavy) is used properly, a force is applied at one point is transformed or magnified, into another, larger force or motion at some other point. In business context, leverage means use of fixed costs in an attempts to magnify (or lever up) profitability. Leverage magnifies variability of EBIT or EPS and thus affects a firm's overall risk and return.

In this chapter we will explore the principles of both operating and financial leverage. The formal is due to fixed operating costs associated with the production of goods and services, while the later is due to the existence of fixed financial costs - in particular, interest on debt.

Operating and Financial Leverage

Fixed costs can be classified into two groups:

a. Operating fixed costs that is administrative expenses, depreciation expenses etc. and

b. Financial fixed costs that is interest expenses, preferred dividend etc.

Operating leverage arises when there are fixed operating cost in the firm's cost structure. On the other hand, financial leverage means use of debt or preferred share in the firm's capital structure. In other hands, when a firm is financially levered, it has to incur certain fixed obligation to some third parties.

Degree of Operating Leverage

Operating leverage magnifies sensitivity of the firm's operating income (or loss) to the level of sales (or volume of activity). A quantitative measure of this sensitivity of a firm's operating profit to a change in the firm's sales is called the degree of operating leverage (DOL).

The degree of operating leverage of a firm at a particular level of output (or sales) is simply the percent change in operating profit (EBIT) resulting from a 1 percent change in output (or sales)

Relative change (% change) in operating profit (EBIT)

DOL =

Relative change (% change) in output (sales)

x (p-v)

=

x (p-v) - F0

EBIT + F0

=

EBIT

Deriving the DOL Formula

By definition

EBIT = Px - Vx - F0

= x (P-V) - F0 -----------------(i)

∆ EBIT = ∆ {x (P-V) - F0} [taking the first order derivative]

∆ EBIT =∆ x (P-V) [since p, v, and F0 do not change]

Divide both sides by equation (i)

∆ EBIT ∆ x (P-V)

=

EBIT x (P-V) - F0

Now divide both sides by ∆ x / x

∆ EBIT / EBIT ∆ x (P-V) / x (P-V) - F0

=

∆ x / x ∆ x / x

∆ x (P-V) x

DOL = .

x (P-V) - F0 ∆x

x (P-V)

DOL =

x (P-V) - F0

x (P-V) - F0 + Fo

=

x (P-V) - F0

EBIT + F0

DOL =

EBIT

Implication of DOL in Profit planning and Control

The greater is a firm's DOL, the more its EBIT will vary with sales fluctuations. DOL is therefore an indicator of business risk (variability of EBIT, if sales vary) of a firm. A high DOL indicated a high risk. In other hands, DOL measures the sensitivity of a firm's operating profit to changes in the volume of sales. The greater the DOL the greater is the sensitivity of EBIT to the volume of sales.

Business Risk refers to the uncertainty or variability of the firm's EBIT. A company with a highly unpredictable EBIT has high business risk.

Operating leverage is often incorrectly used as a synonym for business risk. It is true that the greater is the DOL, the more sensitive is EBIT to a given change in unit sales and that, everything else being equal, a higher DOL means higher business risk. But risk also depends on two other factors: the variability of the firm's sales and the variability of the company's cost and price structure. EBIT can vary not only because sales fluctuate but also because of changes in the company's output, price and costs that is changes in P, F0, and V. Also, if price and costs are uncertain, DOL is uncertain, since DOL is defined in term of P, F0 and V. In this case, the use of DOL in evaluating business risk is somewhat limited.

The degree of operating leverage should thus be viewed as measure of potential "risk" which becomes active only in the presence of sales and production cost variability.

Financial Leverage

Financial leverage