Leverage

Topics: Variable cost, Contribution margin, 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
Universidad Tecnológica de Bolívar
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
Sales &Adm.
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. ...
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