07-11-2012, 12:55 PM
Operating and Financial Leverage
1Operating and Financial.ppt (Size: 239.5 KB / Downloads: 202)
Define operating and financial leverage and identify causes of both.
Calculate a firm’s operating break-even (quantity) point and break-even (sales) point
Define, calculate, and interpret a firm's degree of operating, financial, and total leverage.
Understand EBIT-EPS break-even, or indifference, analysis, and construct and interpret an EBIT-EPS chart.
Define, discuss, and quantify “total firm risk” and its two components, “business risk” and “financial risk.”
Understand what is involved in determining the appropriate amount of financial leverage for a firm.
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).
Impact of Operating Leverage on Profits
Firm F is the most “sensitive” firm -- for it, a 50% increase in sales leads to a 400% 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 firm that is most sensitive to the presence of operating leverage.
Summary of the Coverage Ratio Discussion
A single ratio value cannot be interpreted identically for all firms as some firms have greater debt capacity.
Annual financial lease payments should be added to both the numerator and denominator of the debt-service coverage ratio as financial leases are similar to debt.