Measures of Leverage

By
Dr. Muhammad Ali
Agenda
What is Leverage?
Business Risk and Financial Risk
Sales Risk
Operating Risk
Degree of Operating Leverage (DOL)
Degree of Financial Leverage (DFL)
Degree of Total Leverage (DTL)
Break Even Analysis
Practice Problems
Leverage
Leverage results from using borrowed capital as a funding
source when investing to expand the firm's asset base and
generate returns on risk capital.
Leverage is an investment strategy of using borrowed money
specifically, the use of various financial instruments or 
borrowed capital to increase the potential return of an
investment.
Leverage can also refer to the amount of debt a firm uses to
finance assets.
When one refers to a company, property or investment as
"highly leveraged," it means that item has more debt than
equity.
Leverage
In finance, leverage refers the amount of fixed costs a
firm has.
The fixed costs includes, fixed operating expenses,
(financing cost, building and equipment leases etc).
Greater leverage of a firm indicate its higher level of
variability.
How Leverage Works?
The concept of leverage is used by both investors and
companies.
Investors use leverage to significantly increase the returns
that can be provided on an investment. 
They lever their investments by using various instruments
that include options, futures and margin accounts.
Companies can use leverage to finance their assets. In
other words, instead of issuing stock to raise capital,
companies can use debt financing to invest in business
operations in an attempt to increase shareholder value. 
How Leverage Works?
Leverage is the use of debt (borrowed capital) in order
to undertake an investment or project.
The result is to multiply the potential returns from a
project.
At the same time, leverage will also multiply the
potential downside risk in case the investment does
not pan out.
Example of Leverage
A company formed with an investment of $5 million from
investors, the equity in the company is $5 million; this is
the money the company can use to operate.
If the company uses debt financing by borrowing $20
million, it now has $25 million to invest in business
operations and more opportunity to increase value for
shareholders.
An automaker, for example, could borrow money to build
a new factory. The new factory would enable the
automaker to increase the number of cars it produces and
increase profits.
Business Risk and Financial Risk
Financial risk and business risk are two different types of
warning signs that investors must investigate when
considering making an investment. 
Financial risk relates to how a company uses its financial
leverage and manages its debt load.
Business risk relates to whether a company can make enough
in sales and revenue to cover its expenses and turn a profit.
With financial risk, there is a concern that a company may 
default on its debt payments.
With business risk, the concern is that the company will be
unable to function as a profitable enterprise.
Business Risk and Financial Risk
Business and financial risks are also known as
unsystematic risk.
Business risk is an uncertainty about a firm’s revenues
and expenditures to generate profits.
Business risk is a combination of sales and operating
risk.
Financial risk must bear by firm’s common stock
holder when a firm uses debt financing. (due to fixed
interest expenses)
Sales Risk
Sales risk refers to the uncertainty relating to the price and
quantity of goods that are available for sale to consumers.
Usually, sales risk may result in sales failures, and it can
significantly affect the reported financial performance.
Protecting the business against the sales risk can help
build resilience in a way that the sales team is able to
counter the contributing risk factors.
The sales team should be properly trained on how to
identify, monitor, and control the risk factors of sales risks.
Types of Sales Risk
Operating Risk
Operating risk is the level of uncertainty associated with the core
operations of a business. There are a number of possible causes of
operating risk, including the following:
1. The variability of demand for products
2. The variability of prices for supplies
3. The risk of product obsolescence
4. The risk of equipment obsolescence
5. The risk associated with changes in the management team
6. The risk of failed internal processes
7. The risk of incompetent personnel
8. The risk of employee fraud
Operating risk does not include any risks associated with the financing of
a business.
Degree of Operating Leverage (DOL)
It is define as a % change in operating income (EBIT) due to
% change in sales.
The degree of operating leverage is a method used to
quantify a company’s operating risk. This risk arises due to
the structure of fixed and variable costs.
 Fixed costs do not allow the company to adjust its operating
costs. Therefore, operating risk rises with an increase in the
fixed-to-variable costs proportion.
Generally, a low DOL indicates that the company’s variable
costs are larger than its fixed costs while A high DOL reveals
that the company’s fixed costs exceed its variable costs.
Formulae for DOL
DOL
Important:
The degree of operating leverage can be calculated in several different ways. First,
we can use the formula from the definition of the ratio.
Since the operating leverage ratio is closely related to the company’s 
cost structure, we can calculate it using the company’s contribution margin.
The contribution margin is the difference between total sales and total variable
costs.
Finally, if there is available information about the cost structure of a company, we
can use the following formula.
Where:
Q – the number of units
P – the price per unit
V – the variable cost per unit
F – the fixed costs
DOL Example
Example
The management of ABC Corp. wants to determine
the company’s current degree of operating leverage.
The company sells 10,000 product units at an average
price of $50. The variable cost per unit is $12, while the
total fixed costs are $100,000.
Solution
Degree of Financial Leverage (DFL)
The degree of financial leverage is a financial ratio that
measures the sensitivity in fluctuations of a company’s
overall profitability to the volatility of its operating
income caused by changes in its capital structure.
The degree of financial leverage is one of the methods
used to quantify a company’s financial risk (the risk
associated with how the company finances its
operations).
Formula for DFL
DFL
Important:
There are several ways to calculate the degree of financial leverage. The
choice of the calculation method depends on the goals and context
of the analysis. For example, a company’s management often wants
to decide whether it should or should not issue more debt. In such a
case, net income would be an appropriate measure of the company’s
profitability.
 if an investor wants to determine the effects of the company’s decision
to incur additional leverage, the earnings per share (EPS) is a more
appropriate figure because of the metric’s strong relationship with
the company’s share price.
Finally, there is a formula that allows calculating the degree of
financial leverage in a particular time period
Example for DFL
ABC Corp. is preparing to launch a new project that
will require substantial external financing. The
company’s management wants to determine whether it
can safely issue a significant amount of debt to finance
the new project. Currently, the company’s EBIT is
$500,000, and interest payments are $100,000.
Solution
Degree of Total Leverage (DTL)
The degree of total leverage is a ratio that compares
the rate of change a company experiences in 
earnings per share (EPS) to the rate of change it
experiences in revenue from sales.
The degree of total leverage can also be referred to as
the “degree of combined leverage” because it considers
the effects of both operating leverage and 
financial leverage.
Degree of Total Leverage (DTL)
Components of the Degree of Total Leverage

The two leverages that degree of total leverage accounts for are as
follows:
Operating leverage – This part of a company’s fixed costs reveals
how effectively revenue from sales is translated into 
operating income. A business with a high level of operating leverage
can increase its bottom line significantly with just a relatively small
increase in revenues because it has effectively leveraged its
operating costs so as to maximize profits.
Financial leverage – Financial leverage is a metric used to evaluate
the extent to which a company uses debt to increase its assets and 
net income. Examining a company’s financial leverage shows the
impact on earnings per share of changes in EBIT that result from
taking on additional debt.
Formula for DTL

The degree of total leverage can be explained or calculated simply as:

Degree of total leverage = Degree of operating leverage x Degree of

financial leverage

The degree of operating leverage is equivalent to:

Contribution margin (Total sales – Variable costs) / Earnings before

interest and taxes (EBIT)

The degree of financial leverage is equivalent to:

Earnings before interest and taxes (EBIT) / EBIT – interest expenses

Example of DTL

Let’s put the degree of total leverage into practice by

looking at an example. Assume that Company ABC’s
current EPS is $3, and it is trying to determine what its
new EPS will be in the event that it experiences a 10%
increase in sales revenue.
For our example, also assume the following for
Company ABC:
Contribution margin is $15 million
Fixed costs are $3 million
Interest expenses are $1.5 million
Solution
The first step in determining Company ABC’s new EPS is to calculate the
percentage of response that the current EPS will experience with a 1% change
in revenue from sales, which is also equal to the degree of operating leverage.
The calculation should look something like this:

$15m/$15m – $3m (1.25) x $15m – $3m / $15m – $3m – $1.5m (1.14) = 1.25 x 1.14 =
1.43%

The degree of total leverage for Company ABC is 1.43%. The figure can then
be used to help the company determine what its new EPS will be if it sees a
10% increase in sales revenue. The calculation for the new EPS should look
like this:

$3 (current EPS) x (1 + 1.43 x 10%) = $3.49

Assignment Question
Calculate and interpret the DOL, DOF and DTL for
ATOM and BETA Companies.
Operating costs for Atom and Beta Company
  Atom ($) Beta ($)
Price 4 4
VC 3 2
FC 40,000 120,000
Rev 400,000 400,000