Leverage is an investment strategy which used debt (borrowed capital) to fund an investment or to expand an asset base for a company. Put simply, leverage is the use of debt by a company in order to multiple the potential returns.
Operating Leverage
Operating leverage results from the presence of fixed operating costs in a firm’s income stream. The extent of the presence of fixed operating costs in a firm’s income stream is measured by the degree of operating leverage (DOL).
$$DOL = \dfrac{Percentage\: Change\: in\: Earnings\: Before\: Interest\: and\: Taxes\: (EBIT)}{Percentage\; Change\: in\: Sales}$$
Financial leverage results from the presence of fixed financial costs in a firm’s income stream. The extent of the presence of fixed financial costs in a firm’s income stream is measured by the degree of financial leverage (DFL).
$$DFL = \dfrac{Percentage\: Change\: in\: Net\: Income\: (NI)}{Percentage\: Change\: in\: Earnings\: Before\: Interest\: and\: Taxes\: (EBIT)}$$
Firm’s often have both operating and financial leverage. This total or combined leverage results from the presence of both fixed operating and financial costs in a firm’s income stream. Combined leverage is measured by the degree of combined leverage (DCL).
$$DCL = \dfrac{Percentage\: Change\: in\: Net\: Income\: (NI)}{Percentage\; Change\: in\: Sales}$$
Notice that DCL = DFL × DOL.
Degree of Leverage
Firms that have greater degrees of leverage have greater levels of fixed costs. And as such, they tend to have greater break-even points than do firm’s that do not have leverage. The advantage of having greater degrees of leverage is that as a firm’s sales volume increases beyond the break-even point, its margins improve. The disadvantage of having greater degrees of leverage is that because the break-even point is higher, which means that the firm is required to achieve a higher sales volume in order to reach the break-even point. In good times when sales are high, a higher degree of leverage allows a firm to maximize profits. In bad times when sales are not as good, the firm is able to minimize its losses by having a lower degree of leverage.
Example:
In the example below, a firm’s projected EBIT under two very different cost structures.
| Income Statement | High Leverage | Low Leverage |
|---|---|---|
| Sales | $100,000 (100%) | $100,000 (100%) |
| Variable Operating Costs | -20,000 (-20) | -40,000 (-40) |
| Contribution Margin | 80,000 (80) | 60,000 (60) |
| Fixed Operating Costs | -40,000 (-40) | -20,000 (-20) |
| EBIT | $40,000 (40%) | $40,000 (40%) |
Notice the firm experiences the same level of sales, while it has very different cost structures.
Now notice what happens to the firm under each option when their sales decrease to $50,000.
| Income Statement | High Leverage | Low Leverage |
|---|---|---|
| Sales | $50,000 (100%) | $50,000 (100%) |
| Variable Operating Costs | -10,000 (-20) | -20,000 (-40) |
| Contribution Margin | 40,000 (80) | 30,000 (60) |
| Fixed Operating Costs | -40,000 (-80) | -20,000 (-40) |
| EBIT | $0 (0%) | $10,000 (20%) |
When the sales drop to $50,000, the high leverage option declines to its break-even point while the low leverage option minimizes the loss. Now notice what happens to the firm’s sales increase to $150,000.
| Income Statement | High Leverage | Low Leverage |
|---|---|---|
| Sales | $150,000 (100%) | $150,000 (100%) |
| Variable Operating Costs | -30,000 (-20) | -60,000 (-40) |
| Contribution Margin | 120,000 (80) | 90,000 (60) |
| Fixed Operating Costs | -40,000 (-27) | -20,000 (-13) |
| EBIT | $80,000 (53%) | $70,000 (47%) |
When a firm’s sales increase, the cost structure option with the higher degree of leverage is able to maximize the firm’s profits.
This overview was developed by Eric Maneval.
No adaptation of its content is permitted without permission.