Impact and Analysis of Leverage

(1)

Impact and Analysis

of Leverage

Impact and Analysis

of Leverage

(2)

What is

Leverage?

(3)

What is

Leverage?

(4)

Two concepts that

enhance our

understanding of risk...

1)

Operating Leverage

- affects

a firm’s

business risk

.

(5)

Business Risk

 The variability or uncertainty of a

(6)

Analytical Income Statement

sales

- variable costs - fixed costs

operating income (EBIT) - interest

EBT - taxes

(7)

Business Risk

Affected by:

 Sales volume variability

 Competition

 Product diversification

 Operating leverage

 Growth prospects

(8)

Operating Leverage



The use of

fixed operating costs

as

opposed to

variable operating

costs.



A firm with relatively high fixed

operating costs will experience

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(10)

EBIT

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Operating Leverage

 One potential “effect” caused by the

presence of operating leverage is

that a change in the volume of sales results in a “more than proportional” change in operating profit (or loss).

Operating Leverage

--

_--

The use of

_{The use of}

fixed operating costs by the firm

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Impact of Operating

Leverage on Profits

(13)

Impact of Operating

Leverage on Profits

 Now, subject each firm to a 50% 50%

increase in sales

increase in sales for next year.

 Which firm do you think will be more

“sensitive”

“sensitive” to the change in sales (i.e., show the largest percentage change in operating profit, EBIT)?

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Impact of Operating

Leverage on Profits

Firm F Firm V Firm 2FFirm F Firm V Firm 2F

Change in EBIT

Change in EBIT* 400% 100% 330%400% 100% 330%

(in thousands) (in thousands)

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Impact of Operating

Leverage on Profits

 Firm F Firm F is the most “sensitive” firm is the most “sensitive” firm -- for it, a 50%

increase in sales leads to a 400% increase in EBIT400% increase in EBIT.

 Our example reveals that it is a mistake to assume

that the firm with the largest absolute or relative amount of fixed costs automatically shows the most dramatic effects of operating leverage.

 Later, we will come up with an easy way to spot the

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Break-Even Analysis

 When studying operating leverage,

“profits” refers to operating profits before taxes (i.e., EBIT) and excludes debt

interest and dividend payments.

Break-Even Analysis

Break-Even Analysis -- A technique for studying the relationship among fixed costs, variable costs, sales volume, and

profits

(17)

Quantity

$

(18)

Quantity

{

$

Total Revenue

Total Cost

FC

TOTAL REVENUE

VC

(19)

Quantity

{

$

Total Revenue

Total Cost

FC

Q

1

+

-}

EBIT

(20)

Quantity

{

$

Total Revenue

Total Cost

FC

Break-even

point

Q

1

+

-}

_EBIT

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Operating Leverage

What happens if the firm

increases its fixed operating

costs and reduces (or

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Quantity

{

$

Total Revenue

Total Cost

FC

Break-even point

Q

1

+

(23)

Quantity

{

$

Total Revenue

Total Cost

= Fixed

FC

Break-even

}

Q

1

+

(24)

Quantity

{

$

Total Revenue

Total Cost

the firm has

a higher breakeven

point.

If sales are not

high enough, the firm

will not meet its fixed

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Break-Even

(Quantity) Point

How to find the quantity break-even point: EBIT = PP(QQ) - VV(QQ) - FCFC produced and sold

produced and sold

Break-Even Point

Break-Even Point -- The sales volume required -- The sales volume required

so that total revenues and total costs are

equal; may be in units or in sales dollars.

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Break-Even

(Quantity) Point

Breakeven occurs when EBIT = 0

Q

_(P

P

_{- V}

V

_{) - FC}

FC

= EBIT

Q

_BE_BE

_(P

P

_{- V}

V

_{) - FC}

FC

= 0

Q

_BE_BE

_(P

P

_{- V}

V

)

_{= FC}

FC

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Break-Even (Sales) Point

How to find the sales break-even point:

S

_BE_BE

=

FC

_{+ (VC}

VC

_BE_BE

)

S

_BE_BE

=

FC

_{+ (Q}

Q

_BE_BE

_)(V

V

)

or

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Break-Even

Point Example

Basket Wonders (BW) wants to

determine both the quantity and sales quantity and sales

break-even points

break-even points when:

 Fixed costs Fixed costs are $100,000$100,000

 Baskets are sold for $43.75$43.75 eacheach

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Break-Even Point (s)

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Degree of Operating

Leverage (DOL)

Degree of Operating Leverage

Degree of Operating Leverage -- The percentage change in a firm’s operating

profit (EBIT) resulting from a 1 percent change in output (sales).

=

Percentage change in operating profit (EBIT) Percentage change in

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Computing the DOL

DOL

DOLQ units_{Q units}

Calculating the DOL for a single product

or a single-product firm.

= QQ (PP - VV) Q

Q (PP - VV) - FCFC

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Computing the DOL

DOL

DOLS dollars of sales_{S dollars of sales}

Calculating the DOL for a

multiproduct firm.

= SS - VCVC

S

S - VCVC - FCFC

= EBIT + FCFC

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Break-Even

Point Example

Lisa Miller wants to determine the degree degree

of operating leverage

of operating leverage at sales levels of sales levels of

6,000 and 8,000 units

6,000 and 8,000 units. As we did earlier, we will assume that:

 Fixed costs Fixed costs are $100,000$100,000

 Baskets are sold for $43.75$43.75 eacheach

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Computing BW’s DOL

DOL

DOL6,000 units_{6,000 units}

Computation based on the previously Computation based on the previously calculated break-even point of 4,000 units calculated break-even point of 4,000 units

= 6,0006,000

DOL_{8,000 units}_{8,000 units} 8,0008,000

8,000

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Interpretation of the DOL

A 1% increase in sales above the 8,000 A 1% increase in sales above the 8,000

unit level increases EBIT by 2% unit level increases EBIT by 2% because of the existing operating because of the existing operating

leverage of the firm. leverage of the firm.

= DOL

DOL_{8,000 units}_{8,000 units} 8,0008,000

8,000

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Interpretation of the DOL

2,000

QUANTITY PRODUCED AND SOLD

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Interpretation of the DOL

 DOL is a quantitative measure of the “sensitivity”

of a firm’s operating profit to a change in the firm’s sales.

 The closer that a firm operates to its break-even

point, the higher is the absolute value of its DOL.

 When comparing firms, the firm with the highest

Key Conclusions to be Drawn from the

previous slide and our Discussion of DOL

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DOL and Business Risk

 DOL is only one component one component of business risk

and becomes “active” only in the presence only in the presence

of sales and production cost variability

of sales and production cost variability.

 DOL magnifiesmagnifies the variability of operating

profits and, hence, business risk.

Business Risk

Business Risk -- The inherent uncertainty -- The inherent uncertainty in the physical operations of the firm. Its in the physical operations of the firm. Its

impact is shown in the variability of the impact is shown in the variability of the