Page 156 - DMGT405_FINANCIAL%20MANAGEMENT

Financial Management

Notes 8.5 Summary

 In financial analysis, leverage represents the influence of one financial variable over some
other related financial variable.
 The amount of leverage in the firm’s capital structure can significantly affect its value by
affecting returns and risks.
 Operating leverage is concerned with the relationship between the firm’s sales revenue
and its earnings before interest and taxes, or EBIT

Percentage change in EBIT
 Operating leverage =
Percentage change insales

 Break-even analysis, sometimes called cost volume profit analysis, is used by the firm to
determine the level of operations necessary to cost all operating costs

 High operating leverage is good when revenues are rising and bad when they are falling.
Percentage change in EBIT
 Financial leverage =
Percentage change in EBIT
 The financial leverage is favourable when the firm earns more on the investments/assets
financed by the sources having fixed charges.
 Combined leverage or total leverage can be defined as potential use of fixed costs, both
operating and financial, to magnify the effect of changes in sales on the firms, earnings per
share.

 Combined leverage = operating leverage × financial leverage.

8.6 Keywords

Debt: It is that which is owed; usually referencing assets owed.

Degree of Operating Leverage: It is the change in the percentage of operating income (EBIT) for
the change in percentage of sales revenue.

Financial Leverage: It is the payment of fixed rate of interest for the use for the fixed interest
bearing securities, to magnify the rate of return as equity shares.

Leverage: It allows accomplishing certain things that are otherwise not possible.
Operating Leverage: It results from the present fixed operating expenses within firm’s income
stream.
Operating Risk: It is the risk of the firm not being able to cover its fixed operating costs.

Return on Assets: This percentage shows how profitable a company’s assets are in generating
revenue.
Operating Income: It is a measure of a firm’s profitability that excludes interest and income tax
expenses.

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