Operating and Financial Leverage - Financial Management

The concepts of operating and financial leverage were introduced in the previous chapter. In finance, leverage is defined as a firm’s use of assets and liabilities having fixed costs in an attempt to increase potential returns to stockholders.

Specifically, operating leverage involves the use of assets having fixed costs, whereas financial leverage involves the use of liabilities(and preferred stock) having fixed costs. A firm uses operating and financial leverage in the hope of earning returns in excess of the fixed costs of its assets and liabilities, thereby increasing the returns to common stockholders.

Leverage is a double -edged sword, however, because it also increases the variability or risk of these returns. If, for example, a firm earns returns that are less than the fixed costs of its assets and liabilities, then the use of leverage can actually decrease the returns to common stockholders. Thus, leverage magnifies shareholders’ potential losses as well as potential gains. Leverage concepts are particularly revealing to the financial analyst in that they highlight the risk–return trade-offs of various types of financial decisions, such as those involving the capital structure of the firm.

Leverage and the Income Statement

Financial statements of the Allegan Manufacturing Company are referred to throughout this section for purposes of illustration. Table contains two types of statements for the firm—a traditional format and a revised format. The traditional format shows various categories of costs as separate entries. Operating costs include such items as the cost of sales and general, administrative, and selling expenses. Interest charges and preferred dividends, which represent capital costs, are listed separately, as are income taxes.

The revised format is more useful in leverage analysis because it divides the firm’s operating costs into two categories, fixed and variable.

Short -Run Costs Over the short run, certain operating costs within a firm vary directly with the level of sales whereas other costs remain constant, regardless of changes in the sales level. Costs that move in close relationship to changes in sales are called variable costs. They are tied to the number of units produced and sold by the firm, rather than to the passage of time. They include raw material and direct labor costs, as well as sales commissions.

Over the short run, certain other operating costs are independent of sales or output levels. These, termed fixed costs, are primarily related to the passage of time. Depreciation on property, plant, and equipment; rent; insurance; lighting and heating bills; property taxes; and the salaries of management are all usually considered fixed costs. If a firm expects to keep functioning, it must continue to pay these costs, regardless of the sales level. A third category, semivariable costs, can also be considered.

Semivariable costs are costs that increase in a stepwise manner as output is increased. One cost that sometimes behaves in a stepwise manner is management salaries.Whereas these costs are generally considered fixed, this assumption is not always valid. A firm faced with declining sales and profits during an economic downturn may often cut the size of its managerial staff.

Panels show the behavior of variable, fixed, and semivariable costs, respectively, over the firm’s output range. Not all costs can be classified as either completely fixed or variable; some have both fixed and variable components. Costs for utilities, such as water and electricity, frequently fall into this category.

Whereas part of a firm’s utility costs (such as electricity) is fixed and must be paid regardless of the level of sales or output, another part is variable in that it is tied directly to sales or production levels. In the revised format of Allegan’s income statement, these are divided into their fixed and variable components and are included in their respective categories of operating costs.

Traditional and Revised Income Statements, Allegan Manufacturing Company, Year Ending December 31, 2004

Traditional and Revised Income Statements, Allegan Manufacturing Company, Year Ending December 31, 2004

Note that in the revised income statement format, both interest charges and preferred dividends represent fixed capital costs. These costs are contractual in nature and thus are independent of a firm’s level of sales or earnings. Also note that income taxes represent a variable cost that is a function of earnings before taxes.
Long-Run Costs Over the long run, all costs are variable. In time, a firm can change the size of its physical facilities and number of management personnel in response to changes in the level of sales. Fixed capital costs also can be changed in the long run.

Behavior of (a) Variable, (b) Fixed, and (c) Semivariable Costs

Behavior of (a) Variable, (b) Fixed, and (c) Semivariable Costs

degree of operating leverage (DOL) degree of financial leverage (DFL)

Measurement of Operating and Financial Leverage

Fixed obligations allow a firm to magnify small changes into larger ones—just as a small push on one end of an actual lever results in a large “lift” at the other end. Operating leverage has fixed operating costs for its “fulcrum.”When a firm incurs fixed operating costs, a change in sales revenue is magnified into a relatively larger change in earnings before interest and taxes (EBIT). The multiplier effect resulting from the use of fixed operating costs is known as the degree of operating leverage (DOL).

Financial leverage has fixed capital costs for its “fulcrum.”When a firm incurs fixed capital costs, a change in EBIT is magnified into a larger change in earnings per share (EPS). The multiplier effect resulting from the use of fixed capital costs is known as the degree of financial leverage (DFL).

Degree of Operating Leverage A firm’s degree of operating leverage (DOL) is defined as the multiplier effect resulting from the firm’s use of fixed operating costs.More specifically, DOL can be computed as the percentagechange in earnings before interest and taxes (EBIT) resulting from a given percentage change in sales (output):

DOL at X = Percentage change in EBIT/Percentage change in sales

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