Leverage is that portion of the fixed costs which represents a risk to the firm. Operating leverage, a measure of operating risk, refers to the fixed operating costs found in the firm’s income statement. Financial leverage, a measure of financial risk, refers to financing a portion of the firm’s assets, bearing fixed financing charges in hopes of increasing the return to the common stockholders. The higher the financial leverage, the higher the financial risk, and the higher the cost of capital. Cost of capital rises because it costs more to raise funds for a risky business.
This post provides technical guidelines on how to determine operating and financial leverage. Enjoy!
A discussion of break-even analysis, broadly known as cost/volume/profit analysis, is necessary for understanding the nature and importance of operating leverage. So, before I jump to the financial leverage, let me briefly discuss break-even analysis first. Read on…
Computing Break-Even Analysis
The break-even point is the level of sales at which no profit or loss results. To determine the breakeven point, the costs must be divided into:
- Variable Costs – which are costs that vary in direct proportion to a change in volume; and
- Fixed Costs – which are costs that are constant regardless of volume.
The break-even point can be found easily by setting sales just equal to the total of the variable costs plus the fixed costs:
- S = Sales ($)
- X = Sales volume in units
- P = Selling price per unit
- V = Unit variable cost
- VC = Variable operating costs
- FC = Fixed operating costs
S = VC + FC
PX = VX + FC
(P – V)X = FC
X = FC / (P- V)
Break-Even Sales In Units
= fixed operating costs / (unit selling price – unit variable cost)
The Lie Dharma Company manufactures and sells doors to home builders. The doors are sold for $25 each. Variable costs are $15 per door, and fixed operating costs totaling $50,000. The company’s break-even point is:
X = FC/ (P-V) = $50,000/($25-$15) = 5,000 doors
Therefore, the company must sell 5,000 doors to break even.
Computing Cash Break-Even Point
If a firm has a minimum of available cash or the opportunity cost of holding excess cash is high, management may want to know the volume of sales that will cover all cash expenses during a period. This is known as the “Cash Break-even Point”.
Not all fixed operating costs involve cash payments. For example, depreciation expenses are non-cash charges. To find the cash break-even point, the non-cash charges must be subtracted from total fixed operating costs. Therefore, the cash break-even point is lower than the usual break-even point. The formula is:
X = (FC – d)/ (P – V) –> where d is depreciation expenses
Assume from the previous example that the total fixed operating costs of $50,000 include depreciation in the amount of $2,000. Then the Lie Dharma Company cash break-even point is:
X = (FC–d)/(P-V) = ($50,000-$2,000)/($25-$15) = $48,000/$10 = 4,800 doors
The company has to sell 4,800 doors to cover only the fixed costs involving cash payments of $48,000 and to break even.
Now, we have the foundation enable us to jump to the leverage analysis. Let’s start with the operating leverage. Read on…
How to Compute Operating Leverage
As mentioned on the preface, “Operating Leverage” is a measure of operating risk and arises from fixed operating costs. A simple indication of operating leverage is the effect that a change in sales has on earnings. The formula is:
“Operating Leverage” at a given level of sales (X)
= percentage change in EBIT/percentage change in sales = (P-V)X/(P-V)(X- FC)
EBIT = earnings before interest and taxes = (P-V)X – FC
From the first example, assume that the Lie Dharma Company is currently selling 6,000 doors per year. Its operating leverage is:
= [(P – V)X]/ (P – V) (X –FC)
= [($25 – $15)(6,000)]/ [($25- $15) (6,000)- $50,000]
= $60,000 / 10,000 = 6
Which mean if “Sales” increase by 10 percent, the company can expect its “net income” to increase by six times that amount, or 60 percent.
How To Calculate Financial Leverage
“Financial Leverage” is a measure of financial risk and arises from fixed financial costs. One way to measure financial leverage is to determine how ‘Earnings Per Share [EPS]” are affected by a change in EBIT (or operating income). The formula is:
“Financial Leverage” at a given level of sales (X)
= percentage change in EPS / percentage change in EBIT
= [(P – V)X – FC] / [(P – V)X – FC – IC]
Where EPS is earnings per share, and IC is “Fixed Finance Charges”, i.e., “Interest Expense” or “Preferred Stock Dividends”. [Note: Preferred Stock Dividend must be adjusted for taxes i.e., Preferred Stock Dividend/(1-t).]
Using the data in the operating leverage, the Lie Dharma Company has total financial charges of $2,000, half in “Interest Expense” and half in “Preferred Stock Dividend”. The “Corporate Tax Rate” is 40 percent. What is their financial leverage?
First, Calculate the “Fixed Finance Charge [IC]”:
IC = $1,000 + ($1,000/1- 0.4) = $1,000 + $1,667 = $2,667
Therefore, Lie Dharma’s financial leverage is computed as follows:
= [(P-V)X –FC] / [(P-V)X-FC-IC]
= [($25 – $15) 6,000- $50,000] / [($25-$15)6,000 – $50,000 -$2,667]
= $10,000 / $7,333
Which mean that if EBIT increases by 10 percent, Lie Dharma can expect its EPS to increase by 1.36 times, or by 13.6 percent.
How To Compute Total Leverage
“Total Leverage” is a measure of total risk. The way to measure total leverage is to determine how EPS is affected by a change in sales. The Formula is:
“Total Leverage” at a given level of sales (X)
= percentage change in EPS / percentage change in sales
= operating leverage x financial leverage
= [(P-V)X / (P –V)X – FC] x [(P – V)X – FC/(P-V)X – FC – IC]
= [(P – V)X / [(P – V)X – FC – IC]
From the operating and financial leverage examples, the total leverage for Lie Dharma Company is:
Operating leverage x financial leverage = 6 x 1.36 = 8.16
= [(P – V)X] / [(P-V)X – FC – IC]
= ($25 – $15) (6,000) / [($25 – $15) 6,000 – $50,000 – $2,667
= $60,000 / $7,333 = 8.16 (rounded)