Leverage

Section: Leverage Estimated study time: 45 minutes Content: Leverage in corporate finance refers to the use of fixed costs — either operating fixed costs or financial (debt) costs — to magnify the impact of sales volume changes on profits. There are two types: operating leverage and financial leverage. Operating leverage arises from the cost structure of the business — specifically the proportion of fixed versus variable operating costs. A company with high fixed costs (like an airline or steel manufacturer) has high operating leverage: when revenue rises, a large portion flows to operating profit because fixed costs remain constant. Conversely, when revenue falls, losses accelerate because fixed costs continue regardless. Financial leverage arises from the use of debt: fixed interest payments mean that earnings before interest and taxes (EBIT) changes translate into amplified changes in earnings per share (EPS). The Degree of Operating Leverage (DOL) measures the sensitivity of operating income (EBIT) to changes in sales. DOL = % change in EBIT / % change in Sales. It can also be calculated as: DOL = (Sales – Variable Costs) / (Sales – Variable Costs – Fixed Costs) = Contribution Margin / EBIT. For example, if a company has revenue of $1,000, variable costs of $600, and fixed costs of $200, then contribution margin = $400 and EBIT = $200. DOL = $400 / $200 = 2.0, meaning a 10% increase in sales produces a 20% increase in EBIT. Higher DOL means both greater upside potential when sales grow and greater downside risk when sales fall. The Degree of Financial Leverage (DFL) measures the sensitivity of EPS (or net income) to changes in EBIT. DFL = % change in EPS…