Foundations of Financial Management: An Analysis (part 14)

“The desire of gold is not for gold. It is for the means of freedom and benefit.”

~Ralph Waldo Emerson~

Operating and Financial Leverage

(part C)

by

Charles Lamson

Combining Operating and Financial Leverage

If both operating and financial leverage allow us to magnify our returns, then we will get maximum leverage through their combined use in the form of combined leverage. We have said that operating leverage affects primarily the asset structure of the firm, while financial leverage affect the debt-equity mix. From an income statement viewpoint, operating leverage determines return from operations, while financial leverage determines how the "fruits of our labor" will be allocated to debt holders and, more importantly, to stockholders in the form of earnings per share. Table 6 shows the combined influence of operating and financial leverage on the income statement. The values in Table 6 are drawn from Tables 2 and 5 presented in preceding posts. We assumed in both cases a high degree of operating and financial leverage (i.e., the leveraged firm). The sales volume is 80,000 units.

Table 5 Income statement

You will observe, first, that operating leverage influences the top half of the income statement determining operating income. The last item under operating leverage, operating income, then becomes the initial item for determining financial leverage. "Operating income" and "Earnings before interest and taxes" are one in the same, representing the return to the corporation after production, marketing, and so forth---but before interest and taxes are paid. In the second half of the income statement, we then show the extent to which earnings before interest and taxes are translated into earnings per share. A graphical representation of these points is provided in Figure 5. 

Figure 5

Degree of Combined Leverage

Degree of combined leverage (DCL) uses the entire income statement and shows the impact of a change in sales or volume on bottom-line earnings per share. Degree of operating leverage and degree of financial leverage are, in effect, being combined. Table 7 shows what happens to profitability as the firm's sales go from $160,000 (80,000 units) to $200,000 (100,000 units).

Table 7

The formula for degree of combined leverage is stated as:

Using data from table 7:

Every percentage point change in sales will be reflected in a 4 percent change in earnings per share at this level of operation (quite an impact).

An algebraic statement of the formula is:

From Table 7: Q (Quantity) = 80,000; P (Price per unit) = $2.00; VC (Variable costs per unit) = $0.80; FC (Fixed costs) = $60,000; and I (Interest) = $12,000.

The answer is once again is shown to be 4.

A Word of Caution

In a sense, we are piling risk on risk as the two different forms of leverage are combined. Perhaps a firm carrying heavy operating leverage may wish to moderate its position financially, and vice versa. One thing is certain---the decision will have a major impact on the operations of the firm.

Summary

Leverage may be defined as the use of fixed cost items to magnify returns at high levels of operation. Operating leverage primarily affects fixed versus variable cost utilization in the operation of the firm. An important concept---degree of operating leverage (DOL)---measures the percentage change in operating income as a result of a percentage change in volume. The heavier the utilization of fixed-cost assets, the higher DOL is likely to be.

Financial leverage reflects the extent to which debt is used in the capital structure of the firm. Substantial use of debt will place a great burden on the firm at low levels of profitability. But it will help to magnify earnings per share as volume or operating income increases. We combine operating and financial leverage to assess the impact of all types of fixed costs on the firm. There is a multiplier effect when we use the two different types of Leverage.

Because leverage is a two-edged sword, management must be sure the level of risk assumed is in accord with its desire for risk and its perceptions of the future. High operating leverage may be balanced off against lower financial leverage if this is deemed desirable, and vice versa. 

*MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., PP. 125-129*

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