Measures of Leverage

Introduction

This reading presents elementary topics in leverage. Leverage is the use of fixed costs in a company’s cost structure. Fixed costs that are operating costs (such as depreciation or rent) create operating leverage. Fixed costs that are financial costs (such as interest expense) create financial leverage.

Analysts refer to the use of fixed costs as leverage because fixed costs act as a fulcrum for the company’s earnings. Leverage can magnify earnings both up and down. The profits of highly leveraged companies might soar with small upturns in revenue. But the reverse is also true: Small downturns in revenue may lead to losses.

Analysts need to understand a company’s use of leverage for three main reasons. First, the degree of leverage is an important component in assessing a company’s risk and return characteristics. Second, analysts may be able to discern information about a company’s business and future prospects from management’s decisions about the use of operating and financial leverage. Knowing how to interpret these signals also helps the analyst evaluate the quality of management’s decisions. Third, the valuation of a company requires forecasting future cash flows and assessing the risk associated with those cash flows. Understanding a company’s use of leverage should help in forecasting cash flows and in selecting an appropriate discount rate for finding their present value.

The reading is organized as follows: Section 2 introduces leverage and defines important terms. Section 3 illustrates and discusses measures of operating leverage and financial leverage, which combine to define a measure of total leverage that gauges the sensitivity of net income to a given percent change in units sold. This section also covers breakeven points in using leverage and corporate reorganization (a possible consequence of using leverage inappropriately). A summary and practice problems conclude this reading. 

The member should be able to:

• define and explain leverage, business risk, sales risk, operating risk, and financial risk and classify a risk;

• calculate and interpret the degree of operating leverage, the degree of financial leverage, and the degree of total leverage;

• analyze the effect of financial leverage on a company’s net income and return on equity;

• calculate the breakeven quantity of sales and determine the company's net income at various sales levels;

• calculate and interpret the operating breakeven quantity of sales.