Leverage Ratio

Leverage in general refers to the

potential to earn a high level of return
relative to the amount of cost
expended. Leverage can be
advantageous, but it can also be risky.
Two kinds of leverage will be covered
in this ratio category:
1. financial leverage
2. operating leverage.
Financial Leverage

Financial leverage is the use of debt to

increase earnings. Interest is the cost of
using debt to finance operations. Interest is
a fixed charge because unlike dividends,
interest must be paid whether or not the
firm is profitable. The use of financing that
carries a fixed charge is called financial
leverage.
Financial leverage magnifies the effect of
both managerial success (profits) and
managerial failure (losses).
Advantages of successfully using financial leverage:
• When interest expenses paid on the debt capital is less than the return earned from the
investment of the debt capital (in other words, less than the return on asset), the excess
return benefits the equity investors.
• Interest expense is tax deductible
Financial leverage can also be defined as the percentage of fixed cost financing in a firm’s
overall capital structure, because the increased amount of debt causes the company’s financial
costs (interest expense) to increase.
 A company’s financial leverage is measured by
1) Financial leverage ratio
2) Degree of financial leverage.
1) Financial Leverage Ratio, or Equity Multiplier
The financial leverage ratio, also called the equity multiplier, is calculated as follows:

The financial leverage ratio indicates the amount of debt a firm is using to finance its
assets. The more debt the company has, the higher its financial leverage ratio will be.
A Higher ratio implies that the asset of the company are financed primarily through debt.
A financial ratio of 2 reflects that the liabilities of the company are equal to equity.
A ratio greater than 2 implies that liabilities are larger than equity.
A ratio less than 2 implies that higher equity than liability of company.

A company with financial leverage is said to be “trading on the equity.” “Trading on the equity”
is simply a term that means the company is using financial leverage (debt) in an effort to
achieve increased returns. Trading on the equity, or financial leverage, may or may not be
successful.

• If a leveraged company’s return on assets is greater than its after-tax cost of debt, and
therefore return on common equity is higher, it is said to be successfully trading on the equity,
and its common shareholders will benefit.
• If a leveraged company’s return on assets is less than its after-tax cost of debt, it is said to be
unsuccessfully trading on the equity, and its common shareholders will be hurt.
 Example

Calculate financial leverage ratio for year 1 and year 2.

 Degree of Financial Leverage (DFL)
Measures the degree to which a company's net income changes relative to changes in operating
income (or EBIT). A company with a high degree of financial leverage will experience more
volatility in net income.
The formula results in the DFL for the
earlier of the two periods. This
formula can be used when two
periods of financial information are
available.

This formula can be used

When only one period of
financial information is
available
For the two methods of calculating DFL to result in the same DFL, the following assumptions are required:
• Variable costs represent the same percentage of revenue in both periods, so the contribution margin ratio
(contribution margin divided by revenue) is the same for both periods.
• Total fixed costs are the same for both periods.
• Non-operating gains or losses (and discontinued operations, if applicable), interest income, and interest expense
are the same in both periods.
• The tax rate is the same for both periods.
• EBIT ÷ EBT is used to calculate DFL for the earlier period only.
Example of degree of financial leverage calculated both ways:
A. 0.73
B. 2.27
C. 1.36
D. 2.73
2. A Financial analyst with Mineral Inc. calculated the company’s degree of financial
leverage (DFL) as 1.5. If net income before interest increases by 5%, earnings to
shareholders will increase by:

A. 3.33%
B. 1.5%
C. 7.5%
D. 5.00%
Operating Leverage

The degree to which a company uses

fixed operating costs rather than variable
operating costs

A company with high operating leverage:

❑ Must produce sufficient sales revenue to

cover its high fixed operating costs

❑ Will have greater risk but greater possible

returns

❑ May struggle to cover fixed costs when sales

decline
Operating leverage refers to the extent to which a company utilizes fixed operating costs rather than variable
operating costs in its operations. The concept highlights how changes in sales volume can affect the company's
operating income due to the presence of fixed costs.
Understanding Operating Leverage:
[Link] Costs: These are costs that do not change with the level of production or sales, such as rent, salaries, and
insurance.
[Link] Costs: These costs vary directly with the level of production or sales, such as raw materials and direct
labor.

High Operating Leverage:

•A company with high operating leverage has a higher proportion of fixed costs in its cost structure.
•When sales increase, the company's operating income increases significantly because the fixed costs are spread
over more units, reducing the cost per unit.
•Conversely, when sales decrease, the company's operating income drops sharply because the fixed costs remain
the same, leading to a higher cost per unit.
Low Operating Leverage:
•A company with low operating leverage has a higher proportion of variable costs.
•Changes in sales volume have a less dramatic effect on operating income because costs vary directly with sales.
Real-Life Example:
Imagine a small cafe that operates in a rented space.
Scenario 1: High Operating Leverage Cafe
•Fixed Costs: The cafe pays $5,000 per month in rent, $3,000 in salaries for staff, and $2,000 in other fixed expenses.
Total fixed costs = $10,000.
Variable Costs: The cost of ingredients for each coffee is $1.

If the cafe sells 1,000 cups of coffee per month at $5 each:

•Revenue: 1,000 cups * $5 = $5,000
•Variable Costs: 1,000 cups * $1 = $1,000
•Total Costs: Fixed Costs ($10,000) + Variable Costs ($1,000) = $11,000
•Operating Income: Revenue ($5,000) - Total Costs ($11,000) = -$6,000 (a loss)

If the cafe sells 4,000 cups of coffee:

•Revenue: 4,000 cups * $5 = $20,000
•Variable Costs: 4,000 cups * $1 = $4,000
•Total Costs: Fixed Costs ($10,000) + Variable Costs ($4,000) = $14,000
•Operating Income: Revenue ($20,000) - Total Costs ($14,000) = $6,000 (a profit)
In this scenario, increasing sales significantly improves operating income because the fixed costs are spread over
more units.
Scenario 2: Low Operating Leverage Café
•Fixed Costs: The cafe pays $2,000 per month in rent, $1,500 in part-time staff salaries, and $500 in other fixed
expenses. Total fixed costs = $4,000.
•Variable Costs: The cost of ingredients for each coffee is $3.

If the cafe sells 1,000 cups of coffee per month at $5 each:

•Revenue: 1,000 cups * $5 = $5,000
•Variable Costs: 1,000 cups * $3 = $3,000
•Total Costs: Fixed Costs ($4,000) + Variable Costs ($3,000) = $7,000
•Operating Income: Revenue ($5,000) - Total Costs ($7,000) = -$2,000 (a loss)
If the cafe sells 4,000 cups of coffee:
•Revenue: 4,000 cups * $5 = $20,000
•Variable Costs: 4,000 cups * $3 = $12,000
•Total Costs: Fixed Costs ($4,000) + Variable Costs ($12,000) = $16,000
•Operating Income: Revenue ($20,000) - Total Costs ($16,000) = $4,000 (a profit)
In this scenario, the change in sales volume has a less dramatic impact on operating income due to the higher
proportion of variable costs.
Key Takeaway: Operating leverage demonstrates how fixed costs can amplify the effects of changes in sales on a
company's profitability. High operating leverage can lead to higher profits with increased sales but also higher risks
with decreased sales. Low operating leverage results in more stable operating income with less sensitivity to sales
fluctuations.
A company that has invested heavily in automated production equipment is an example of a company with
high operating leverage. The company will have high fixed costs for the equipment. At the same time, it will
have low variable costs. Labor is a variable cost of production, and the company with automated production
equipment will have less need for labor and thus lower variable costs than would a company with labor-
intensive production processes. In order for the high operating leverage to be successful, however, the
company must earn a contribution margin that is high enough to cover the high fixed costs. Once the
contribution margin has covered the fixed costs, though, increases in the contribution margin as a result of
increased sales go straight to increase EBIT.

When comparing two or more companies’ operating results, the company with a higher
proportion of fixed costs in its cost structure will have higher operating leverage (all other
things being equal). For the company with higher operating leverage, small changes in sales
will lead to larger changes in EBIT, both positive and negative. If the company’s sales increase,
EBIT will increase relatively more than the sales increase. If sales decrease, EBIT will decline
relatively more than the sales decrease.