Page 143 - DMGT310_ENTREPRENEURSHIP_AND_SMALL_BUSINESS_MANAGEMENT

Entrepreneurship and Small Business Management

Notes variable cost in the output. We shall be considering three types of leverage ratios and their
implications. These include (a) debt-to-equity ratio, (b) degree of combined leverage1 and,
(c) degree of operating leverage.
Debt to equity ratio is a measure of venture’s financial leverage. It is arrived at by dividing total
liabilities of the venture by the equity. It informs the proportion of equity and debt in the capital
structure of the venture.

Total Liabilities
Debt to Equity Ratio =
Equity
A further precision is possible if only interest bearing, long-term debt is used instead of total
liabilities. High debt/equity ratio generally implies venture financing by debt and higher
interest burden that can affect the profitability in the event of downturn. High debt/equity ratio
also indicates greater control by the entrepreneur. Debt-equity ratio also varies from industry
to industry. Capital-intensive industries have higher incidence of debt-equity ratio relative to
less capital-intensive industries.
Degree of combined leverage ratio summarizes the combined effect the Degree of Operating
Leverage (DOL), and the degree of financial leverage has on Earnings Per Share (EPS), given a
particular change in sales. This ratio can be used to help determine the most optimal level of
financial and operational leverage to use in any firm. Additionally, it indicates the effect this
combination or variation in this combination has on venture earnings.

% Change Earning Per Share (EPS)
Degree of Combined Leverage Ratio =
% Changes in Sales
One interpretation of the high level of combined leverage is higher amount of risk associated
with the venture as high leverage may imply higher fixed costs.
Degree of operating leverage indicates the effect a particular amount of operating leverage has
on venture’s Profit Before Interest and Taxes (PBIT).

!
Caution It uses higher share of fixed costs to variable costs in venture operations.
Higher level of operating leverage will impart higher amount of volatility to venture profits
before interest and tax relative to the changes in the sales.

% Change in Profit Before Interest & Taxes
Degree of Operating Leverage =
% Changes in Sales
This ratio also assists in understanding the effect a specific level of operating leverage exerts on
earning potential of the venture. This is possible to be used as a beacon for arriving at optimum
level of operating leverage so that profit before interest and taxes may be maximized.

Self Assessment

Fill in the blanks:

9. ……………are calculated from current year numbers and are then compared to previous
years.
10. Ratios are commonly used for ……….. analysis.

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