Measuring Leverage - Understanding Financial and Operating Leverage
Leverage is the amount of fixed costs a firm has. Fixed costs, which are costs that remain the same irrespective of a company’s sales or level of production, include both operating costs (rent/depreciation) and financial costs (e.g. interest expense).
Greater leverage = more variability in after-tax earnings and net income and a higher susceptibility to suffering during economic downturns.
This higher volatility means investors in the company bear more risk. Because of this, an analyst should use a higher discount rate when valuing a company with high leverage.
On the CFA Level 1 exam in leverage is introduced in Reading 27 within the corporate finance study session. The purpose here is to better understand project financing and to tie back our work with financial statements to apply a framework to understand how to value a company based on its relative risk.
Why Understanding Leverage matters?
It is important to understand a company’s amount of leverage because:
- The degree of leverage is vital for understanding a company’s risk and return profile
- The degree of leverage gives detailed insight into a company’s business structure and future prospect
- It is vital to selecting the right discount rate to evaluate future cash flow streams
Types of Risk Facing a Firm
Business risk refers to the risk associated with a firm’s operating income. It’s the result of uncertainty around either revenue (sales risk) or costs (operating risk). It can be caused by macro conditions, industry dynamics, government regulation, or demographics.
Operating risk is the incremental risk caused by higher fixed operating costs. The greater the Fixed/Variable cost ratio the greater the operating risk.
Sales risk is uncertainty about the firm’s sales.
Businesses have more control over operating risk than sales risk.
Financial risk is the additional risk that common shareholders take on when the firm takes on additional fixed debt (which happens because shareholders are further down the priority line in event of bankruptcy). It is the uncertainty of net future cash flows.
Financial and Operating Leverage
There are two types of leverage—financial and operating.
- If a firm is using operating leverage a given change in sales leads to a greater change in operating earnings.
- If a firm is using financial leverage a given change in sales leads to a greater change in net income.
Let’s break that down a bit more.
Operating leverage is the degree to which a company uses fixed costs in its operations.
The higher the % of fixed costs the higher the company's operating leverage.
For companies with high operating leverage, a small change in company revenues will result in a larger change in operating income since most costs are fixed rather than variable.
Calculating the Degree of Operating Leverage (DOL)
We measure the degree of operating leverage as the ratio of the percentage change in operating income (EBIT) to the percentage change in units sold.
Note that DOL is different at different quantities of sales. The higher the sales, the lower the degree of operating leverage becomes (As Q↑, DOL ↓). Intuitively this should make sense, the sensitivity of EBIT to a change in units sold is lower at high volume. You can also think about DOL with respect to its similarities to elasticity:
A few other things to keep in mind regarding DOL:
- DOL is negative when EBIT is negative, and positive when EBIT is positive
- DOL is most sensitive around EBIT = 0
- DOL is undefined (mathematically) when EBIT = 0
- The lower overall company leverage the less sensitive EBIT is to changes in units sold
- The greater the DOL (the higher fixed costs) the harder it is for the business to adjust to changes in sales
- Higher operating leverage indicates more upfront investment to produce the product
- The lower the operating leverage the greater the variable costs of sales
Financial leverage is the degree to which a company uses debt or preferred equity. In this case:
- The more debt, the higher the interest payments, and the lower earnings per share.
- The more preferred equity the higher the dividend payments, and the lower EPS
- The more debt the more risk there is to common equity holders
We measure financial risk based on the sensitity of cash flow available to owners against changes in operating income (EBIT).
Calculating the Degree of Financial Leverage
Formally, the degree of financial leverage is the ratio of the percentage change in net income (or earnings per share) to the percentage change in earnings before interest and taxes:
Key Characteristics of DFL:
- DFL is not affected by the tax rate
- DFL changes depending on the level of operating income
- Management has influence on the DFL
- Companies that invest more in tangible assets have a higher DFL
- If a company is profitable, DFL ↑ , ROE ↑, and the rate of change of ROE is higher (think about the assets/equity component of the DuPont formula)
- DFL ↑, common equity risk ↑, default risk ↑
Tips for Identifying and Calculating DOL & DFL
- If there are no fixed costs, DOL = 1, no operating leverage
- If there are no interest costs, DFL = 1, no financial leverage
Thus values of 1 = no leverage
- In a calculation if you plug zero in for fixed costs, DOL = 1
- In a calculation if you plug zero in for interest, DFL = 1
Calculating the Degree of Total Leverage
The degree of total leverage (DTL) measures the sensitivity of EPS to changes in sales. DTL is the combined effect of operating and financial leverage:
Where: S = Sales, TVC = Total Variable Costs, F = Fixed Costs
Calculating a Firm's Breakeven Point(s)
The breakeven quantity of sales is the quantity of sales at which revenues equal total costs and net income is zero. We calculate the breakeven quantity as:
You should be able to see a few things from this graph:
- The higher the operating/financial leverage, the greater the break-even point.
- The further from break-even we go the greater the amplifying effect of the leverage, i.e. while leverage creates more risk it also amplifies a company’s potential for profit
Another way to consider this break-even point is to ignore the financial costs and look only at the operating costs.
In other words the operating breakeven quantity of sales simply drops the financing costs from the breakeven quantity of sales calculation to show the point where revenues equal operating costs.
Summarizing Firm Leverage for CFA L1
Leverage is another consideration in corporate finance. It is not enough to look at a potential project or company's financial return. You also have to assess the degree of risk involved with achieving that return. Leverage--whether financial or otherwise--is a key component of understanding a firm's capital structure and how it needs to perform. Expect a few questions on the L1 exam asking you to use the equations presented here or to interpret a break-even chart.