# Leverage

Pages: 16 (1122 words) Published: March 5, 2013
16/07/2010

Degree of leverage
• The degree of leverage in a firm is
calculated based on various indexes.

Leverage:, Operating,
Financial and Total

Some common indexes are:
Engineering Economy
Ignacio Vélez Pareja
Professor
http://www.cashflow88.com/

1.Degree of operating leverage, DOL
2.Degree of financial leverage, DFL
3.Degree of total leverage, DTL

http://www.cashflow88.com/decisiones/decisiones.html

ivelez@unitecnologica.edu.co
nachovelez@gmail.com
Cartagena

7/16/2010

Financial and Ratio Analysis.
Vélez

1

Operating Leverage

Financial and Ratio Analysis.
Vélez

7/16/2010

2

Variable Costing
Q * USP – Q * (UVC +UVE) – FC – FE = EBIT

• Operating leverage is the degree
to which a firm uses fixed costs in
its operations. The higher the
relative fixed costs (% of total
costs), the higher the firm's
degree of operating leverage. In
firms with high degree of
operating leverage, a small
change in revenues will result in a
larger change in operating income
because most costs are fixed.

7/16/2010

Financial and Ratio Analysis.
Vélez

UPS = Unit Sales Price, UVC = unit variable cost,
UVE = unit variable expense, FC = fixed costs,
FE Fixed
FE = Fixed expenses
Q * [USP – (UVC +UVE)] –

UCM

FC – FE

= EBIT

Fixed
cost

CM

3

1

16/07/2010

Degree of operating
Leverage

Degree of Operating
Leverage DOL
• Degree of operating leverage
(DOL
(DOL) is the percentage change in
EBIT, divided by the percentage
change in sales. It is a measure of
the sensitivity of EBIT to changes
in sales due to changes in
operating expenses.

7/16/2010

Financial and Ratio Analysis.
Vélez

Apalancamiento
Operativo

5

DOL =

7/16/2010

ΔEBIT
ΔSales

MC

=

EBIT

Financial and Ratio Analysis.
Vélez

6

Example

Sales Revenues
- Variables Costs
and expenses
CONTRIBUTION
MARGIN
- Fixed Costs and expenses
Earnings before
Interest and Taxes
(EBIT)
- Interest expenses

Volume of Sales
Sa
in units
Unit Selling Price
Unit variable cost
Fixed Costs
Fixed Expenses

20,000
\$ 10
\$6
\$ 5,000
\$ 3,500

Earning before taxes
(EBT)
- Taxes
Net Income

2

16/07/2010

Effect on EBIT
Change in sales

20%

Sales in units

16,000

Sales in \$

20,000

24,000

160,000 200,000 240,000

Variable Costs

96,000 120,000 144,000

Contribution Margin

64,000

80,000

96,000

FC production

5,000

5,000

5,000

GF A&V

3,500

3,500

3,500

55,500

71,500

EBIT
Impact on EBIT
DOL

-22.38%

87,500
22.38%

1,12

• The effect on EBIT is an amplified
effect and it goes in both ways.
• We say that there is operating
leverage when the effect is larger
than 1: When the firm has fixed costs,
there is operating leverage.
• A mnemonic device to help in
reminding DOL is that, if fixed costs
are 0, and then DOL will be equal to
1.
• To have a high DOL does not mean a
good financial health. If there is
prosperity, to have high DOL is good,
BUT in a recession it is bad.
• DOL is a measure of risk.

Apalancamiento
Financiero

Financial Leverage

Sales Revenues

• Financial leverage is the degree to which a
company uses fixed items, such as debt and
preferred equity. A high degree of financial
leverage implies high interest payments. As a
result, earnings per share are negatively
influenced by interest charges. The higher
interest payments due to increased financial
leverage, the lower Earnings per Share, EPS.

-Variable costs
and expenses
CONTRIBUTION
MARGIN

Financial risk is the risk to the shareholders
caused by an increase in debt and preferred
equities in the firm’s capital structure. When a
firm increases preferred equities and debt,
interest charges increase, and EPS are reduced. ...