Leverage refers to the use of fixed costs in a company’s cost structure. Fixed operating costs introduce operating leverage and fixed financial costs result in financial leverage. Leverage increases the volatility of a company’s returns, results in greater risk and warrants the use of a higher discount rate for the company’s valuation. A highly leveraged (levered) company has a greater chance of incurring significant losses (gains) as a result of small changes in revenue.

If we plot net income on the y-axis and sales in units on the x-axis, a highly levered company’s net income has a higher slope i.e. greater fluctuation. It is because its net income changes more rapidly in response to a change in sales.

Business risk and financial risk

Risk arises from operating and financing activities of a company.

Business risk

Business risk is the risk associated with operating earnings, which can arise from the variability of revenue (sales risk) or variability of fixed/variable costs (operating risk).

Business\ risk = Sales\ risk + Operating\ risk

Sales risk represents uncertainty with respect to the price and quantity of goods resulting from competition, regulation, demographic changes. Operating risk emanates a company’s cost structure, the use of fixed costs relative to variable costs. When a company has a high proportion of fixed costs, it has less flexibility to respond to market changes.

Degree of operating leverage

The degree of operating leverage is a measure of elasticity of net income to changes in units sold. There are a number of equations used to work out the degree of operating leverage (DOL):

DOL=\frac{\%\ Change\ in\ Operating\ Income}{\%\ Change\ in\ Units\ Sold}
DOL=\frac{Q\times(P-V)}{Q\times(P-V)-F}

A degree of operating leverage of n means that a 1% change in units sold would result in n percent change in operating income. DOL changes with changes in output, i.e. it is not constant for a company at all sales levels. DOL is most sensitive when operating income is close to $0.

The operating risk significantly affects a company’s business risk, but it is determined, to a large extent, by the industry in which a company operates and its business model. Industries that have high operating leverage are those which invest upfront and incur very little variable cost per unit. Examples include software developers, pharmaceutical companies, etc. Alternatively, retailers have low operating leverage.

Since most companies have more than one product, precise ratios of fixed and variable costs are not available, hence in practice, we usually need to regress operating income on company-wide sales to determine operating leverage in existence.

Financial risk

The risk inherent in security depends both on the company’s business risk and associated financial risk. Financial risk refers to risk resulting from a company’s capital structure. Financial risk varies with the use of debt and other fixed obligations, such as leases. Financial risk does not increase with reinvestment of earnings or issuance of common shares.

Degree of financial leverage

Degree of financial leverage (DFL) measures the sensitivity of a company’s net income to changes in operating income:

DFL=\frac{\%\ Change\ in\ Net\ Income}{\%\ Change\ in\ Operating\ Income}
DOL=\frac{Q\times(P-V)-F}{Q\times(P-V)-F-C}

Using more debt financing results in higher fixed financing costs which in turn increases the sensitivity of net income to operating income.

Just like operating leverage depends on a sales level, financial leverage depends on the level of operating income. However, while operating leverage is primarily dictated by a company’s industry, financial leverage is chosen by management. However, companies with large tangible non-current assets tend to have higher debt and high financial leverage because it is easier for them to raise financing. Further, companies whose revenue has below-average sensitivity to the business cycle are better able to raise debt.

Financial leverage generally increases the volatility of return on equity but at the same time also results in a higher return on equity. Financial leverage magnifies positive returns in good times and may cause a default in downturns.

Total leverage

Total leverage represents the combined effect of all fixed costs (both operating and financing) on a company’s profitability. The degree of total leverage is the product of the degree of operating leverage and degree of financial leverage, and it measures the sensitivity of net income to changes in sales units.

DTL=\frac{\%\ Change\ in\ Net\ Income}{\%\ Change\ in\ Units\ Sold}
DTL=DOL\times DFL
DTL=\frac{Q\times(P-V)}{Q\times(P-V)-F-C}

The degree of total leverage varies with the sales level. Fixed operating and financial costs together increase the sensitivity of earnings to owners.

Breakeven points and operating breakeven points

A breakeven point is the sales level (in units or revenue) at which its net income is zero. In other words, at the breakeven points, revenues are equal to costs.

If Q is the number of units sold, P is the price per unit, V is the variable cost per unit, F is fixed operating costs and C is the fixed financing costs, we can create the following expression between revenues and costs:

PQ=VQ+F+C

A bit of rearrangement gets us this equation:

Q_B=\frac{F+C}{P-V}=\frac{Total\ Fixed\ Costs}{Contribution\ Margin\ per\ Unit}

Sometimes, we calculate the operating breakeven point, the sales level at which operating profit is zero. Since no amount would be available to cover fixed financing costs C, the expression for operating breakeven point is as follows:

PQ=VQ+F
Q_{OB}=\frac{F}{P-V}=\frac{Fixed\ Operating\ Costs}{Contribution\ Margin\ per\ Unit}

The break-even point is most important for companies with high operating and financial leverage. It is because as a business expands or contracts beyond the breakeven point, fixed costs do not change and any change in revenue in excess of variable costs increases profit.

Risks of creditors and owners

A company’s business and financial risk affects different providers of capital differently. Providers of debt capital must be paid the pre-defined interest payment or else the company would be forced to go into bankruptcy. Providers of equity capital do not enjoy such senior claims on cash flows, but they enjoy the ability to take all major business decisions. Leverage affects return that accrues to them most significantly because the company might run into a situation in which they might not even receive their investment back.

The existence of high operating leverage coupled with high financial leverage reduces a company’s flexibility to respond to changing market conditions and leads companies into bankruptcies. Different countries have different legal codes dealing with bankruptcy, for example, in the US, there are two primary types of bankruptcy proceedings: (a) reorganization, in which a company receives temporary protection from creditors while it attempts to revive its business, and (b) liquidation, in which a company’s assets are sold off and the cash is paid to creditors in their seniority ranking.

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