Chapter 16 Operating and Financial Leverage 16-1
16-1
Operating and Financial Leverage Operating Leverage ◆ Financia| Leverage ◆ Total Leverage Cash-Flow ability to Service Debt Other Methods of Analysis e Combination of methods 16-2
16-2 u Operating Leverage u Financial Leverage u Total Leverage u Cash-Flow Ability to Service Debt u Other Methods of Analysis u Combination of Methods
Operating Leverage Operating Leverage The use of fixed operating costs by the firm 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) 16-3
16-3 uOne 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 (in thousands) Firm F Firm v Firm 2F Sales $10 $11$195 Operating Costs Fixed 14 Variable Operating Profit 1 $2$2.5 FC/total costs 78 22 82 FC/sales 70 18 n72 16-4
16-4 Sales $10 $11 $19.5 Operating Costs Fixed 7 2 14 Variable 2 7 3 Operating Profit FC/total costs .78 .22 .82 FC/sales .70 .18 .72
Impact of Operating Leverage on Profits Now, subject each firm to a 50% increase in sales for next year Which firm do you think will be more Sensitive to the change in sales(i.e, show the largest percentage change in operating profit, EBIT? [ Firm F;[] Firm V;[I Firm 2F 16-5
16-5 u Now, subject each firm to a for next year. u Which firm do you think will be more to the change in sales (i.e., show the largest percentage change in operating profit, EBIT)? [ ] ; [ ] ; [ ]
Impact of Operating Leverage on Profits (in thousands) Firm F Firm V Firm 2F Sales $15$165$2925 Operating Costs Fixed 2 14 Variable 3 10.54.5 Operating Profit 5 $4 $10.75 Percentage Change in EBIT* 400% 100% 330% 16-6 (EBITt-EBITM1/EBIT +1
16-6 Sales $15 $16.5 $29.25 Operating Costs Fixed 7 2 14 Variable 3 10.5 4.5 Operating Profit * * (EBITt - EBIT t-1 ) / EBIT t-1
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 le presence of 16-7 operating leverage
16-7 -- for it, a 50% increase in sales leads to a . u 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. u Later, we will come up with an easy way to spot the firm that is most sensitive to the presence of operating leverage
Break-Even Analysis Break-Even Analysis -A technique for studying the relationship among fixed costs, variable costs, profits, and sales volume When studying operating leverage, profits refers to operating profits before taxes i.e, EBIT)and excludes debt interest and dividend payments 16-8
16-8 u When studying operating leverage, profits refers to operating profits before taxes (i.e., EBIT) and excludes debt interest and dividend payments. -- A technique for studying the relationship among fixed costs, variable costs, , and sales volume
Break-Even Chart Total Revenues Profits 250 Total Costs 175 留 100 Fixed Costs Losses Variable Costs 50 =----m 010002,0003,0004,0005,0006,0007,000 16-9 QUANTITY PRODUCED AND SOLD
16-9 0 1,000 2,000 3,000 5,000 6,000 7,000 250 100 50
Break Even Quantity) Point Break-Even Point- The sales volume required so that total revenues and total costs are equal; may be in units or in sales dollars How to find the quantity break-even point EBIT=P(Q)-(Q)-FC EBIT=Q(P-V-FC P= Price per unit V= Variable costs per unit FC= Fixed costs Q= Quantity(units) 16-10 produced and sold
16-10 How to find the quantity break-even point: EBIT = ( ) - ( ) - EBIT = ( - ) -
