Description
In finance, leverage (sometimes referred to as gearing in the United Kingdom and Australia) is a general term for any technique to multiply gains and losses.[1] Common ways to attain leverage are borrowing money, buying fixed assets and using derivatives
Study on Operating, Financial and Total: Leverage
16/03/2012
Operating Leverage
• 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.
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Leverage Vélez-Pareja (c)
3
Variable Costing
Q * USP - Q * (UVC +UVE) - FC - FE = EBIT Q * [USP - (UVC +UVE)] FC - FE = EBIT
UCM CM
Fixed cost
USP = Unit Selling Price, UVC = unit variable cost, UVE = unit variable expense, FC = fixed costs, FE = Fixed expenses , EBIT = Earnings before Interest and Taxes, UCM= Unitary contribution margin, CM = Contribution margin
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2
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Degree of Operating Leverage DOL
• Degree of operating leverage
(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.
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Degree of operating Leverage
DOL? ? CM EBIT
Observe that DOL at the extreme right of formula is calculated from actual figures for Contribution Margin and EBIT while in the middle, is calculated with the expected change of EBIT and Sales. Fixed costs are kept constant because precisely DOL measures the effect of having those fixed costs on the change of EBIT. This means that DOL IS NOT measured with the change from one year to another.
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6
3
16/03/2012
Apalancamiento Operativo
Sales Revenues - Variables Costs and expenses CONTRIBUTION MARGIN - Fixed Costs and expenses Earnings before Interest and Taxes (EBIT) - Interest expenses Earning before taxes (EBT) - Taxes Net Income
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Example
Volume of Sales in units Unit Selling Price Unit variable cost Fixed Costs Sales & Adm. Fixed Expenses
20,000 $ 10 $6 $ 5,000 $ 3,500
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4
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Change in sales Sales in units Sales in $ Variable Costs Contribution Margin FC production GF A&V EBIT Impact on EBIT DOL
-20% 16,000 20,000
+20% 24,000
160,000 200,000 240,000 96,000 120,000 144,000 64,000 5,000 3,500 55,500 -22.38% 1,12 80,000 5,000 3,500 71,500 96,000 5,000 3,500 87,500 22.38%
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Effect on EBIT
• 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 this: 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.
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Leverage Vélez-Pareja (c)
10
5
16/03/2012
Financial Leverage
• 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 consequence, earnings per share are negatively influenced by interest charges. The higher interest payments due to increased financial leverage, the lower Earnings per Share, EPS. 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. As a result, risk to shareholder return increases. A firm should take into account its "optimal capital" structure when making financing decisions to make sure any increases in preferred equity and debt increase the value of the firm.
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Apalancamiento Financiero
Sales Revenues -Variable costs and expenses CONTRIBUTION MARGIN - Fixed costs and expenses EBIT
- Interest expenses Earnings before taxes EBT - Taxes Net Income
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6
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• This is the percentage change in EPS
Degree of Financial Leverage
divided by the percentage change in EBIT. This is the "degree of financial leverage" (DFL). It is a measure of the sensitivity of EPS to changes in EBIT as a result of changes in debt. It can be seen as a sort of elasticity. • A mnemonic device to help in reminding DFL is that, if interest is 0, DFL will be equal to 1.
DFL? ? % EPS %EBIT EBIT EBIT - interest charges
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Degree of financial leverage DFL
?EBT ?EBIT EBIT EBT
DFL? ?
Observe that DFL at the extreme right of formula is calculated from actual figures for EBIT and EBT while in the middle, is calculated with the expected change on EBT and EBIT. Interest payments are considered fixed costs and are kept constant because precisely DFL measures the effect of having those financial costs on the change of EBT. This means that DFL IS NOT measured with the change from one year to another.
16/07/2010
Leverage Vélez-Pareja (c)
14
7
16/03/2012
Example Degree of Financial Leverage
• A firm has annual sales of $8 million.
The firm's gross margin is 60%, and fixed costs are $3 million. The firm's annual interest expenses are $100,000. If we increase EBIT by 20%, how much will the company's EPS increase? The company's DFL is calculated as follows: DFL = ($8-$3.2-$3)/( ($8-$2.2-$3-$0.1) DFL = $1.8/$1.7 = 1.059 If EBIT increases by 20%, the DFL indicates EPS will increase 21.2% (20%×1.059 = 21.2%)
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Example
Debt Interest
100,000 2% Taxes 40%
Number of common shares
2,000
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8
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DFL? ?
?EBT ?EBIT
-22.38%
EBIT EBT
+22.38% 8 7 ,5 0 0 2 ,0 0 0 8 5 ,5 0 0 3 4 ,2 0 0 5 1 ,3 0 0 2 5 .6 5 2 3 ,0 2 %
EBIT Interests EBT Taxes Net Income EPS DFL
5 5 ,5 0 0 7 1 ,5 0 0 2 ,0 0 0 2 ,0 0 0
5 3 ,5 0 0 6 9 ,5 0 0 2 1 ,4 0 0 2 7 ,8 0 0 3 2 ,1 0 0 4 1 ,7 0 0 1 6 .0 5 1 ,0 3 2 0 .8 5
Impact on EPS -23,02%
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Degree of Total Leverage DTL
• Combining DOL with DFL we
obtain the degree of total leverage (DTL). If a company has a high DOL and DFL, a small change in sales will lead to a large change in EPS.
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9
16/03/2012
Apalancamiento Total
Sales revenues - Variable costs and expenses CONTRIBUTION MARGIN - Fixed costs and expenses EBIT
- Interest expenses EBT - Taxes Net Income
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Degree of Total Leverage
DTL? ?
CM EBT
?
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10
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Homework
• Companies A and B have the following Income
Statements : Sales Variable Costs Contribution Margin Fixed costs EBIT Interests EBT 4,000 2,000 2,000 1,000 1,000 $0 1,000 4,000 2,000 2,000 0 2,000 1,000 1.000
• If taxes are 30% and the number of shares is
600.
- Calculate the different leverages and explain. - Which firm is in better financial shape?
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21
11
doc_524804861.docx
In finance, leverage (sometimes referred to as gearing in the United Kingdom and Australia) is a general term for any technique to multiply gains and losses.[1] Common ways to attain leverage are borrowing money, buying fixed assets and using derivatives
Study on Operating, Financial and Total: Leverage
16/03/2012
Operating Leverage
• 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.
16/07/2010
Leverage Vélez-Pareja (c)
3
Variable Costing
Q * USP - Q * (UVC +UVE) - FC - FE = EBIT Q * [USP - (UVC +UVE)] FC - FE = EBIT
UCM CM
Fixed cost
USP = Unit Selling Price, UVC = unit variable cost, UVE = unit variable expense, FC = fixed costs, FE = Fixed expenses , EBIT = Earnings before Interest and Taxes, UCM= Unitary contribution margin, CM = Contribution margin
16/07/2010
Leverage Vélez-Pareja (c)
4
2
16/03/2012
Degree of Operating Leverage DOL
• Degree of operating leverage
(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.
16/07/2010
Leverage Vélez-Pareja (c)
5
Degree of operating Leverage
DOL? ? CM EBIT
Observe that DOL at the extreme right of formula is calculated from actual figures for Contribution Margin and EBIT while in the middle, is calculated with the expected change of EBIT and Sales. Fixed costs are kept constant because precisely DOL measures the effect of having those fixed costs on the change of EBIT. This means that DOL IS NOT measured with the change from one year to another.
16/07/2010
Leverage Vélez-Pareja (c)
6
3
16/03/2012
Apalancamiento Operativo
Sales Revenues - Variables Costs and expenses CONTRIBUTION MARGIN - Fixed Costs and expenses Earnings before Interest and Taxes (EBIT) - Interest expenses Earning before taxes (EBT) - Taxes Net Income
16/07/2010 Leverage Vélez-Pareja (c) 7
Example
Volume of Sales in units Unit Selling Price Unit variable cost Fixed Costs Sales & Adm. Fixed Expenses
20,000 $ 10 $6 $ 5,000 $ 3,500
16/07/2010
Leverage Vélez-Pareja (c)
8
4
16/03/2012
Change in sales Sales in units Sales in $ Variable Costs Contribution Margin FC production GF A&V EBIT Impact on EBIT DOL
-20% 16,000 20,000
+20% 24,000
160,000 200,000 240,000 96,000 120,000 144,000 64,000 5,000 3,500 55,500 -22.38% 1,12 80,000 5,000 3,500 71,500 96,000 5,000 3,500 87,500 22.38%
16/07/2010
Leverage Vélez-Pareja (c)
9
Effect on EBIT
• 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 this: 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.
16/07/2010
Leverage Vélez-Pareja (c)
10
5
16/03/2012
Financial Leverage
• 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 consequence, earnings per share are negatively influenced by interest charges. The higher interest payments due to increased financial leverage, the lower Earnings per Share, EPS. 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. As a result, risk to shareholder return increases. A firm should take into account its "optimal capital" structure when making financing decisions to make sure any increases in preferred equity and debt increase the value of the firm.
16/07/2010
Leverage Vélez-Pareja (c)
11
Apalancamiento Financiero
Sales Revenues -Variable costs and expenses CONTRIBUTION MARGIN - Fixed costs and expenses EBIT
- Interest expenses Earnings before taxes EBT - Taxes Net Income
16/07/2010 Leverage Vélez-Pareja (c) 12
6
16/03/2012
• This is the percentage change in EPS
Degree of Financial Leverage
divided by the percentage change in EBIT. This is the "degree of financial leverage" (DFL). It is a measure of the sensitivity of EPS to changes in EBIT as a result of changes in debt. It can be seen as a sort of elasticity. • A mnemonic device to help in reminding DFL is that, if interest is 0, DFL will be equal to 1.
DFL? ? % EPS %EBIT EBIT EBIT - interest charges
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Leverage Vélez-Pareja (c)
13
Degree of financial leverage DFL
?EBT ?EBIT EBIT EBT
DFL? ?
Observe that DFL at the extreme right of formula is calculated from actual figures for EBIT and EBT while in the middle, is calculated with the expected change on EBT and EBIT. Interest payments are considered fixed costs and are kept constant because precisely DFL measures the effect of having those financial costs on the change of EBT. This means that DFL IS NOT measured with the change from one year to another.
16/07/2010
Leverage Vélez-Pareja (c)
14
7
16/03/2012
Example Degree of Financial Leverage
• A firm has annual sales of $8 million.
The firm's gross margin is 60%, and fixed costs are $3 million. The firm's annual interest expenses are $100,000. If we increase EBIT by 20%, how much will the company's EPS increase? The company's DFL is calculated as follows: DFL = ($8-$3.2-$3)/( ($8-$2.2-$3-$0.1) DFL = $1.8/$1.7 = 1.059 If EBIT increases by 20%, the DFL indicates EPS will increase 21.2% (20%×1.059 = 21.2%)
16/07/2010
Leverage Vélez-Pareja (c)
15
Example
Debt Interest
100,000 2% Taxes 40%
Number of common shares
2,000
16/07/2010
Leverage Vélez-Pareja (c)
16
8
16/03/2012
DFL? ?
?EBT ?EBIT
-22.38%
EBIT EBT
+22.38% 8 7 ,5 0 0 2 ,0 0 0 8 5 ,5 0 0 3 4 ,2 0 0 5 1 ,3 0 0 2 5 .6 5 2 3 ,0 2 %
EBIT Interests EBT Taxes Net Income EPS DFL
5 5 ,5 0 0 7 1 ,5 0 0 2 ,0 0 0 2 ,0 0 0
5 3 ,5 0 0 6 9 ,5 0 0 2 1 ,4 0 0 2 7 ,8 0 0 3 2 ,1 0 0 4 1 ,7 0 0 1 6 .0 5 1 ,0 3 2 0 .8 5
Impact on EPS -23,02%
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Leverage Vélez-Pareja (c)
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Degree of Total Leverage DTL
• Combining DOL with DFL we
obtain the degree of total leverage (DTL). If a company has a high DOL and DFL, a small change in sales will lead to a large change in EPS.
16/07/2010
Leverage Vélez-Pareja (c)
18
9
16/03/2012
Apalancamiento Total
Sales revenues - Variable costs and expenses CONTRIBUTION MARGIN - Fixed costs and expenses EBIT
- Interest expenses EBT - Taxes Net Income
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Degree of Total Leverage
DTL? ?
CM EBT
?
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Leverage Vélez-Pareja (c)
20
10
16/03/2012
Homework
• Companies A and B have the following Income
Statements : Sales Variable Costs Contribution Margin Fixed costs EBIT Interests EBT 4,000 2,000 2,000 1,000 1,000 $0 1,000 4,000 2,000 2,000 0 2,000 1,000 1.000
• If taxes are 30% and the number of shares is
600.
- Calculate the different leverages and explain. - Which firm is in better financial shape?
16/07/2010
Leverage Vélez-Pareja (c)
21
11
doc_524804861.docx