OPERATING AND FINANCIAL

LEVERAGE
LEVERAGE IN BUSINESS
(MORA, KAITLYN R.)

CVP ANALYSIS
(MINOR, DIANA)

SALES MIX
(MORRISON, KYSTREL)

OPERATING LEVERAGE
(SOLANO, RUZZED)
(SORIANO, DOMINIC)

FINANCIAL LEVERAGE
(MOVILLA, KIMBERLY)
(SIOSON, MICHAEL)

COMBINING OPERATING AND FINANCIAL LEVERAGE

(PACIS, MARIEL)

BSBA FM 2A (GROUP II)

MR. ARMANDO ROBLES

FINANCIAL MANAGEMENT INSTRUCTOR
LEVERAGE IN BUSINESS

What Is Leverage?
Leverage results from using borrowed capital as a funding source when
investing to expand the firm's asset base and generate returns on risk
capital. Leverage is an investment strategy of using borrowed money—
specifically, the use of various financial instruments or borrowed
capital—to increase the potential return of an investment.
Leverage can also refer to the amount of debt a firm uses to finance
assets.
Understanding Leverage
Leverage is the use of debt (borrowed capital) in order to undertake
an investment or project. The result is to multiply the potential
returns from a project. At the same time, leverage will also multiply
the potential downside risk in case the investment does not pan out.
When one refers to a company, property, or investment as "highly
leveraged," it means that item has more debt than equity.
The concept of leverage is used by both investors and companies.
Investors use leverage to significantly increase the returns that can
be provided on an investment. They lever their investments by using
various instruments, including options, futures, and margin accounts.
Companies can use leverage to finance their assets. In other words,
instead of issuing stock to raise capital, companies can use debt
financing to invest in business operations in an attempt to increase
shareholder value.
Investors who are not comfortable using leverage directly have a
variety of ways to access leverage indirectly. They can invest in
companies that use leverage in the normal course of their business to
finance or expand operations—without increasing their outlay.
Leverage amplifies possible returns, just like a lever can be used to
amplify one's strength when moving a heavy weight.

Special Considerations
Through balance sheet analysis, investors can study the debt and
equity on the books of various firms and can invest in companies that
put leverage to work on behalf of their businesses. Statistics such as
return on equity (ROE), debt to equity (D/E), and return on capital
employed (ROCE) help investors determine how companies deploy capital
and how much of that capital companies have borrowed.
To properly evaluate these statistics, it is important to keep in mind
that leverage comes in several varieties, including operating,
financial, and combined leverage.
Fundamental analysis uses the degree of operating leverage. One can
calculate the degree of operating leverage by dividing the percentage
change of a company's earnings per share (EPS) by its percentage
change in its earnings before interest and taxes (EBIT) over a period.
Similarly, one could calculate the degree of operating leverage by
dividing a company's EBIT by EBIT less interest expense. A higher
degree of operating leverage shows a higher level of volatility in a
company's EPS.
DuPont analysis uses the "equity multiplier" to measure financial
leverage. One can calculate the equity multiplier by dividing a firm's
total assets by its total equity. Once figured, one multiplies the
financial leverage with the total asset turnover and the profit margin
to produce the return on equity. For example, if a publicly traded
company has total assets valued at $500 million and shareholder equity
valued at $250 million, then the equity multiplier is 2.0 ($500
million / $250 million). This shows the company has financed half its
total assets by equity. Hence, larger equity multipliers suggest more
financial leverage.
If reading spreadsheets and conducting fundamental analysis is not
your cup of tea, you can purchase mutual funds or exchange-traded
funds (ETFs) that use leverage. By using these vehicles, you can
delegate the research and investment decisions to experts.

Leverage vs. Margin

Margin is a special type of leverage that involves using existing cash
or securities position as collateral used to increase one's buying
power in financial markets. Margin allows you to borrow money from a
broker for a fixed interest rate to purchase securities, options, or
futures contracts in the anticipation of receiving substantially high
returns.
You can thus use margin to create leverage, increasing your buying
power by the marginable amount—for instance, if the collateral
required to purchases $10,000 worth of securities is $1,000 you would
have a 1:10 margin (and 10x leverage)

Example of Leverage
A company was formed with a $5 million investment from investors,
where the equity in the company is $5 million—this is the money the
company can use to operate. If the company uses debt financing by
borrowing $20 million, it now has $25 million to invest in business
operations and more opportunity to increase value for shareholders.
An automaker, for example, could borrow money to build a new factory.
The new factory would enable the automaker to increase the number of
cars it produces and increase profits.

How Leverage Can Benefit Your Business

Leverage is a concept in both business and investing situations. In
business, leverage refers to how a business acquires new assets for
startup or expansion. It can be used as a noun, as in, "Leverage is a
way to allow a business to expand...." or it can be a verb, as in,
"Businesses leverage themselves by getting loans for expansion."
When a business is "leveraged," it means that the business has
borrowed money to finance the purchase of assets. Businesses can also
use leverage through equity, by raising money from investors.

The Meaning of Leverage in Business

The concept of leverage in business is related to a principle in
physics where it refers to the use of a lever that gives the user a
mechanical advantage in moving or lifting objects. Without leverage,
such a task might not be accomplished.
Leverage involves using capital (assets), usually cash from loans to
fund company growth and development in a similar way, through the
purchase of assets. Such growth could not be accomplished without the
benefit of additional funds gained through leverage.

How Leverage Works—An Example

A small retailer wants to expand into an available space next door in
a strip mall. In addition to increased rent, the business will have to
buy fixtures, shelves, tables, and other operational necessities. It
will also require additional inventory.
Most small businesses don't have sufficient cash on hand to cover all
these expenditures, so the retailer applies for a business loan. This
loan is leverage. It allows the business to do what it couldn't do
without the additional funds.

How to Measure Leverage - The Debt/Equity Ratio

Before we discuss whether leverage is good or bad, it's important to
know how leverage is measured. Accountants and investment analysts
measure leverage using a financial tool called the debt-to-equity
ratio.
The debt-equity ratio measures the amount of debt a business has
compared to the equity (ownership amount) of the owners. The debt-
equity ratio is shown on the business balance sheet.
To figure the debt-equity ratio, start with "liabilities," and include
short-term debt, the current portion of long-term debt (the part
that's due this year), and long-term debt.
The lower the ratio, the greater a company's safety. The general rule
of thumb is that a debt-to-equity ratio greater than 40 or 50% should
be carefully watched.

Look at the debt-to-equity ratio of your business compared with other

similar businesses in your industry to see how your business stands
with industry averages. This article by the University of Wisconsin-
Madison has some sources you can use to measure your company's debt-
to-equity ratio and other financial calculations.
Leverage is usually thought of as bank loans, but it can also be other
kinds of obligations. For example, you might be able to use trade
credit—using vendors as creditors—to leverage your company's credit
record by using vendors as a financing mechanism.

Two Ways to Leverage From Borrowing

You can leverage your business using either financial leverage or
operating leverage.
Financial leverage is leverage from traditional borrowing from a bank
or other lender while operating leverage comes from activities like
trade financing and payables.

Leveraged Buyouts
A leveraged buyout is the purchase of a business using borrowed money.
The assets of the company being bought are used as collateral for the
loans by the buyer. The idea is that the assets will immediately
produce a strong cash flow.

Is Leverage a Good Thing?

Leverage can be a good thing provided that the business doesn't take
on too much debt and is unable to pay it all back.
Operating and financial leverage affect your business differently.
Leverage from operating liabilities typically levers profitability
more than financing leverage and has a higher frequency of favorable
effects.
Disadvantages of Leverage
Leverage is a multi-faceted, complex tool. The theory sounds great,
and in reality, the use of leverage can be profitable, but the reverse
is also true. Leverage magnifies both gains and losses. If an investor
uses leverage to make an investment and the investment moves against
the investor, their loss is much greater than it would've been if they
have not leveraged the investment.
For this reason, leverage should often be avoided by first-time
investors until they get more experience under their belts. In the
business world, a company can use leverage to generate shareholder
wealth, but if it fails to do so, the interest expense and credit risk
of default destroy shareholder value.

KEY TAKEAWAYS
● Leverage refers to the use of debt (borrowed funds) to amplify
returns from an investment or project.
 ● Investors use leverage to multiply their buying power in the
market.
● Companies use leverage to finance their assets—instead of issuing
stock to raise capital, companies can use debt to invest in
business operations in an attempt to increase shareholder value.

COST-VOLUME-PROFIT (CVP) ANALYSIS

CVP Analysis is a method of cost accounting that looks at the
impact that varying levels of costs and volume have on operating
profit.

Main Components of CVP Analysis:

a. Contribution Margin Ratio and Variable Expense Ratio

b. Break-even point

c. Margin of safety

d. Changes in Net Income

e. Degree of Operating Leverage

Contribution Margin (CM) Income Statement Example:.

A XYZ Company sells 10,000 units of a product at Php10 each. The

variable costs are Php.4/unit and fixed costs are Php.30,000.

Total Per Unit

Sales 100,000 10

Less: 40,000 4
Variable
costs

Contribution 60,000 6
Margin

Less: Fixed 30,000

costs

Net income 30,000

Variable costs are the direct and indirect expenses incurred by a
business from producing and selling goods and services. Examples
direct materials, production supplies and per unit labor.

Fixed costs are expenses incurred that don't fluctuate when there are
changes in the production volume or service produced.

Contribution Margin is the amount of revenue available after the

variable cost to cover the fixed expenses and provide profit to the
company.

a. Contribution Margin Ratio and Variable Expense Ratio

CM RATIO

- This ratio shows the amount of money available to cover fixed

cost. The higher the ratio, the more money product sold and its
available to cover all other expense.

Formula:

CM Ratio = Contribution Margin / Sales

= 6 / 10

= 0.6 or 60 %

Variable Expense Ratio

- It is use to determine the amount of fixed cost that it incurs.

A high variable expense ratio implies that a business can earn a
profit relatively low sales level and there are fixed costs to pay
for.

Formula:

Variable Expense Ratio = Total Variable Cost / Sales

=
40,000 / 100,000

= 0.4 or 40 %

b. Break-Even Point

- BEP (in units), the number of products the company must sell
to cover all products costs. Similarly, BEP (in peso), the amount of
sales the company must generate to cover all production costs.
 Formula:

BEP (in units) = Total Fixed Cost / CM per unit

= 30,000 / 6

= 5,000 units

BEP (in peso) = BEP (in units) × Selling Price per unit

= 5,000 × 10

= 50,000

c. Changes in Net Income (What-if Analysis)

- What if the company think to change the net income? How many
units they need to sell to get that target income?

Formula:

No. of Units = (Fixed Cost + Target Profit) / CM per unit

= 30,000 + 70,000 / 6

= 100,000 / 6

= 16,666.66 units

d. Margin of Safety

- Is a built in cushion allowing for some losses to be incurred

without major effect.

Formula:

MOS = Actual Sales - BEP (in peso)

= 100,000 - 50,000

= 50,000

e. Degree of Operating Leverage (DOL)

- DOL measures how much a company's operating income changes in

response to a change in sales.

Formula:

DOL = C.M. / Net Income

 = 60,000 / 30,000

= 2

SALES MIX
What is Sales Mix?

-The sales mix is a calculation that determines the proportion of each

product a business sells relative to total sales. The sales mix is
significant because some products or services may be more profitable
than others and if a company's sales mix changes, it profits also
changes.

-Analysts and investors uses company's sales mix to determine the

company's prospects for overall growth and profitability.

-Sales mix is a combination.

• Sales Mix formula or Breakeven Point

WHERE:

S-VC=CM

S= Sales

VC= Variable Cost

CM= Contribution Margin

Ex. Situation of Sales Mix

In a company or business, they had different products or services

offers to a customer that has something to do with each other. For
example, I am selling a motorcycle but I am not only selling a
motorcycle, I am not limited in just one product, instead,I am also
selling things or products that are related to a motorcycle like its
parts or pieces. Another example, in a foodchain or fast food chain
like Jollibee, they were not settling and selling just one product
like burger but they also had chicken, fries and etc, that compliments
their main product and that availble in that foodchain. In other
terms, sales mix is not settling or concentrating in just one product
or services and from the term itself "mix" there is a combination of
two or more products or services in a company or business.

Ex.Computation

CVP Multiple Products

Products

(S-VC=CM × Mix = Avg CM)

Chicken 60-25=35 × 1/5 =7

Burger 20-12=8 × 2/5 = 3.20

Fries 10-3=7 × 2/5 = 2. 80

Avg CM or the Average Contribution Margin

C-$7.00

B-$3.20

F-$2.80

*That would be the contribution of each product or services for each

unit. The total of that is $13.00

*To get the total of units we will calculate the CM $13x minus the
Fixed Cost lets say $26,000 equals the Net income which is 0.

CM $13x - FC 26,000 =∅

x=26,000 ÷ 13 = 2000 units

*To divide this 2000 units into three which is the three products; the
burger, chicken and fries, we will divide 2000 into the three
portions.

Chicken 2000÷ 1/5=400 units

Burger 2000÷ 2/5=800 units

Fries 2000÷ 2/5=800 units

OPERATING LEVERAGE
      The firm's usage of fixed operational costs. It aids in
determining what percentage of a company's overall costs are made up
of fixed and variable costs, as well as measuring a company's
effectivity utilizing fixed cost items. Ability of the company to
generate enough money to pay all fixed and variable operational costs.
Operating leverage is present any time a firm has fixed operating
costs – regardless of volume. In the long run, of course, all costs
are variable. Consequently, our analysis necessarily involves the
short run. We incur fixed operating costs in the hope that sales
volume will produce revenues more than sufficient to cover all fixed
and variable operating costs.
It is essential to note that fixed operating costs do not vary as
volume changes. These costs include such things as depreciation of
buildings and equipment, insurance, part of the overall utility bills,
and part of the cost of management. On the other hand, variable
operating costs vary directly with the level of output. These costs
include raw materials, direct labor costs, part of the overall
utility.
Table of Operating leverage.

As shown on the table above, In Frame A we find three different firms

possessing various amounts of operating leverage. Firm F has a heavy
amount of fixed operating costs (FC) relative to variable costs (VC).
Firm V has a greater dollar amount of variable operating costs than of
fixed operating costs. Finally, Firm 2F has twice the amount of fixed
operating costs as does Firm F. Notice that, of the three firms shown,
Firm 2F has (1) the largest absolute dollar amount of fixed costs and
(2) the largest relative amount of fixed costs as measured by both the
(FC/total costs) and (FC/sales) ratios.
Each firm is then subjected to an anticipated 50 percent increase in
sales for next year.
The results are shown in Frame B of Table above, For each firm, sales
and variable costs increase by 50 percent. Fixed costs do not change.
All firms show the effects of operating leverage (that is, changes in
sales result in more than proportional changes in operating profits).
But Firm F proves to be the most sensitive firm, with a 50 percent
increase in sales leading to a 400 percent increase in operating
profit. As we have just seen, it would be an error to assume that the
firm with the largest absolute or relative amount of fixed costs
automatically shows the most dramatic effects of operating leverage. 

Break Even Analysis

To illustrate break-even analysis as applied to the study of operating
leverage, it is technique for studying the relationship among fixed
costs, variable costs, sales volume, and profits.  We wish to study
the relationship between total operating costs and total revenues. One
means for doing so is with the break-even chart on the table below,
which shows the relationship among total revenues, total operating
costs, and profits for various levels of production and sales. As we
are concerned only with operating costs at this point, we define
profits here to mean operating profits before taxes. This definition
purposely excludes interest on debt and preferred stock dividends.
These costs are not part of the total fixed operating costs of the
firm and have no relevance when it comes to analyzing operating
leverage.
Example: 
A high-quality child’s bicycle helmet that sells for $50 a unit. The
company has annual fixed operating costs of $100,000, and variable
operating costs are $25 a unit regardless of the volume sold.

Break-Even(Quantity) Point. The intersection of the total costs line

with the total revenues line determines the break-even point. The
break-even point is the sales volume required for total revenues to
equal total operating costs or for operating profit to equal zero. In
Figure below this break-even point is 4,000 units of output (or
$200,000 in sales). Mathematically, we find this point (in units) by
first noting that operating profit (EBIT) equals total revenues minus
variable and fixed operating costs:

To compute for Break even Quantity point (QBE) we have a computation

below:

QBE= Fixed cost/(Selling Price − Variable cost )

  = $100,000/($50 − $25)
  = 4,000 units
For additional increments of volume above the break-even point, there
are increases in profits, which are represented by the darker area in
Figure above. Likewise, as volume falls below the break-even point,
losses increase, which are represented by the lighter area.

Break even (Sales) point

Calculating a break-even point on the basis of dollar sales instead of
units is often useful. When determining a general break-even point for
a multiproduct firm, we assume that sales of each product are a
constant proportion of the
firm’s total sales. Recognizing that at the break-even (sales) point
the firm is just able to cover its fixed and variable operating costs.
To compute for Break even Sales point (SBE) we have the computation
below.
SBE = Break even units × Price per unit
    = 4000 units × $50
    = $200,000       
• As we can see on the figure above as the quantity produced increase
there is also increase in the revenue and operating cost. Also the
fixed cost is on the straight line that means it is constant while
variable cost is not because it change overtime depending on the
quantity produced by a firm. So to easily modify break-even (quantity)
and break-even (sales) point just calculate the sales volume (in units
or dollars) required to produce a “target” operating income (EBIT)
figure. The resulting answers will be your target sales volume – in
units and dollars, respectively – needed to produce your target
operating income figure.

DEGREE OF OPERATING LEVERAGE

    A quantitative measure of this sensitivity of a firm’s operating
profit to a change in the firm’s sales is called the degree of
operating leverage (DOL). The degree of operating leverage of a firm
at a particular level of output (or sales) is simply the percentage
change in operating profit over the percentage change in output (or
sales) that causes the change in profits.
    The sensitivity of the firm to a change in sales as measured by
DOL will be different at each level of output (or sales). Therefore,
we always need to indicate the level of output (or sales) at which DOL
is measured – as in DOL at Q units

DIFFERENT WAYS ON GETTING THE DOL

 BASED ON THE DEFINITION

 MULTI-PRODUCT FIRMS

 SINGLE-PRODUCT FIRMS

DOL AND THE BREAK-EVEN POINT

    We see that the further we move from the firm’s break-even point,
the greater is the absolute value of the firm’s operating profit or
loss and the lower is the relative sensitivity of operating profit to
changes in output (sales) as measured by DOL.
DOL approaches positive (or negative) infinity as sales approach
the break-even point from above (or below) that point. DOL approaches
1 as sales grow beyond the break-even point. This implies that the
magnification effect on operating profits caused by the presence of
fixed costs diminishes toward a simple 1-to-1 relationship as sales
continue to grow beyond the break-even point. And even firms with
large fixed costs will have a low DOL if they operate well above their
break-even point. By the same token, a firm with very low fixed costs
will have an enormous DOL if it operates close to its break-even
point.

DOL AND BUSINESS RISK

    It is important to recognize that the degree of operating leverage
is only one component of the overall business risk of the firm.
Business Risk is the inherent uncertainty in the physical operations
of the firm. Its impact shows in the variability of the firm’s
operating income. The other principal factors giving rise to business
risk are variability or uncertainty of sales and production costs. The
firm’s degree of operating leverage magnifies the impact of these
other factors on the variability of operating profits. Hence, the
degree of operating leverage itself is not the source of the
variability.

A quantitative measure of this sensitivity of a firm’s operating

profit to a change in the firm’s sales. – Degree of Operating Leverage
The inherent uncertainty in the physical operations of the firm. Its
impact shows in the variability of the firm’s operating income. –
Business Risk

FINANCIAL LEVERAGE
involves the use of fixed cost financing. Financial leverage, on the
other hand, is always a choice item. No firm is
required to have any long-term debt or preferred stock financing.
Firms can, instead, finance
operations and capital expenditures from internal sources and the
issuance of common stock.

Financial Leverage (Debt) Ratios

1. Debt-to-Equity Ratio
2. Debt-to-Total-Assets Ratio
3. Long-term-Debt-to-Total- Capitalization Ratio
DEBT- TO - EQUITY RATIO - a financial ratio indicating the relative
proportion of shareholders' equity and debt used to finance a
company's assets.

DEBT- TO- TOTAL - ASSETS RATIO- It shows how much of a business is

owned by creditors, compared with how much of the company's assets are
owned by shareholders.

LONG-TERM-TO-TOTAL-CAPITALIZATION RATIO- a solvency measure that shows

the degree of financial leverage a firm takes on.
 1. Debt-to-Equity Ratio

FORMULA:
Total debt
Shareholders` equity

For Aldine, at year-end 20X2 this ratio is

2. Debt-to-Total-Assets Ratio

FORMULA:
Total debt
Total assets

For Aldine, at the end of 20X2 this ratio is

3. Long-term-Debt-to-Total- Capitalization Ratio

FORMULA:

Long-term debt
Total capitalization

For Aldine, at the end of 20X2 this ratio is

EBIT-EPS break-even analysis- the effect of financing alternatives on
earnings per share. The break-even point is the EBIT level where EPS
is the same for two (or more) alternatives.

Calculation of Earnings per Share. To illustrate an EBIT-EPS break-

even analysis of financial leverage, suppose that Cherokee Tire
Company with long-term financing of $10 million, consisting entirely
of common stock equity, wishes to raise another $5 million for
expansion through one of three possible financing plans. The company
may gain additional financing with a new issue of (1) all common
stock, (2) all debt at 12 percent interest, or (3) all preferred stock
with an 11 percent dividend. Present annual earnings before interest
and taxes (EBIT) are $1.5 million but with expansion are expected to
rise to $2.7 million. The income tax rate is 40 percent, and 200,000
shares of common stock are now outstanding. Common stock can be sold
at $50 per share under the first financing option, which translates
into 100,000 additional shares of stock. To determine the EBIT-EPS
break-even, or indifference, points among the various financing
alternatives, we begin by calculating earnings per share, EPS, for
some hypothetical level of EBIT using the following formula:

Where:
I = annual interest paid
PD = annual preferred dividend paid
t = corporate tax rate
NS = number of shares of common stock outstanding
COMBINING OPERATING AND FINANCIAL LEVERAGE
Is the combination of both operational and financial leverage. It
tells the impact of change in sale to the earning per share (EPS). DCL
shows us the best combination of operational and financial leverage
that is used in the company. It shows the balance between operational
risk and financial risk.

• Operating leverage measures the effect of a change in sales

on EBIT and it is used to calculate a company’s break-even point
and help set appropriate selling prices to cover all costs and
generate a profit. It explains the degree of operating risk.

• Financial leverage measures the effect of a change in

operating EBIT or EPS, it explains the degree of financial risk.

Operating and financial leverage can be combined into an overall

measure called "total leverage. " Total leverage can be used to
measure the total risk of a company and can be defined as the
percentage change in stockholder earnings for a given change in sales.
In other words, total leverage measures the sensitivity of earnings to
changes in the level of a company's sales.

Combined leverage (OL + FL) represents a company’s total risk related

to operating leverage, financial leverage, and the net effect on the
EPS.

Finance managers may calculate combined leverage to make more precise

decisions.

When these two leverages are combined it indicates the effect of

change in sales on EPS. This combined leverage or composite leverage
can be computed as follows:
Example:
EREHWON Company Ltd. sold 2,000 units at $10 per unit.

The company’s variable cost is per unit, and the fixed cost equals
$2,000.

The debt burden is 10% on 400 bonds of $10 each, and the equity
capital comprises 300 shares of $10 each.

The company should come under the tax bracket of 50%.

Calculate

1. EBIT and EPS

2. Combined leverage
Assuming that the company has increased sales by 10%, comment on the
performance.
EPS=

Normal situation = 6

EPS =

Increased sales situation = 7

Combined Leverage

% change in EPS

=16.67% % change in Sales

= 10%

Combined Leverage

= 1.67
Therefore, DCL = 1.67.

Degree of Total Leverage (DTL) is also known as the degree of

combined leverage (DCL). DTL at base sales level
DTL =

Where:
Q = Base level of sales

P = Sales price

VC = Variable costs

FC = Fixed costs

I = Interest on debt

PD = Preferred stock dividend

T = Tax rate

DTL = DOL × DFL

Example:
ABC Co, a computer part manufacturing, expects its sales for the
coming year of 20,000 units. The sales price is at $5 per unit. To
reach this sales level, ABC Co must meet the following obligations:

The variable operating costs per unit is at $2

The fixed operating costs is at $10,000

Interest expense is $20,000

The preferred stock dividend for the year is $12,000

ABC Co pays tax at 40% of its profits. Currently, the company has
common shares outstanding for 5,000 shares.

Calculate the degree of total leverage of ABC Co assuming that the

level of sales would increase 50% on current expected sales.

Solution
In the calculation below, we will illustrate the calculation of degree
operation leverage, degree of financial leverage and the degree of
total leverage.

Below are the relevant formula for each degree of leverage:

DOL = DFL = DTL =

Based on the information above, we can summary the financial data as

per the table below:

We can calculate the DTL of a given sales level of 20,000

units as per the formula below: DTL at base sales level

DTL =

Where:

Q = 20,000 units

P = $5 per unit

VC = $2 per unit

FC = $10,000

I = $20,000

PD = $12,000

T = 40%
Thus, we can calculate the DTL as follow:

DTL =

DTL =

DTL = DOL × DFL

DOL = 1.20

DFL = 5.0

Therefore,

DTL = DOL × DFL

DTL = 1.20 × 5.0
= 6.0
All the formula above give the same result with is at 6.0.

Interpretation And Analysis

The effect of total leverage results from the changes in the firm’s
EPS over the sales revenue.

Typically, the total leverage exists when the percentage change in

earnings per share (EPS) as a result of the percentage change in sales
revenue is greater than the percentage change in sales revenue or it
is greater than 1.

In the cases above, since the DTL is greater than 1, thus total
leverage does exist. The higher the value as calculated in both cases
above, the greater the degree of total leverage.

The calculation of this second formula is a more direct method of

calculating the DTL of a given base level of sales revenue. It is
probably being easier formula to calculate with considering the
changes in both EPS and sales revenue.

The degree of total leverage (DTL) reflects the combined impact of

both the degree of operating leverage and the degree of financial
leverage. Therefore, the higher the DOL and DFL will result in a
higher of DTL. The combined leverage here does not refer to the
addition between DOL and DFL. However, it refers to the multiplication
between the two leverages as you can see in the last formula we
illustrated above.

Key points:
• Total leverage measures the sensitivity of earnings to changes in
the level of a company's sales.
• If the percentage change in earnings and the percentage change in
sales are both known, a
company can simply divide the percentage change in earnings by the
percentage change in sales to determine total leverage.

• Companies usually choose one form of leverage over the other when
analyzing potential investments. A company utilizing both forms of
leverage undertake a very high level of risk.

DTL and Total Firm Risk

Operating leverage and financial leverage can be combined in a
number of different ways to obtain a desirable degree of total
leverage and level of total firm risk. High business risk can
be offset with low financial risk and vice versa. The proper
overall level of firm risk involves a trade-off between total
firm risk and expected return. This trade-off must be made in
keeping with the objective of maximizing shareholder value.
https://www.investopedia.com/terms/l/leverage.asp
https://learn.financestrategists.com/explanation/financial-
statements/combined-leverage/
https://www.investopedia.com/terms/o/
operatingleverage.asp#:~:text=Operating%20leverage%20is%2 0a
%20cost,costs%20has%20high%20operating%20leverage.
https://www.accountingtools.com/articles/2017/5/14/financial-
leverage#:~:text=Financial%20leverage%20is%20the%20use,increase%20the
%20return%20on%20equit
y.&text=The%20financial%20leverage%20formula%20is,the%20amount%20of
%20financial%20leverage.
 SELF ASSESTMENT:
I. IDENTIFICATION
I. It is also called borrowed capital?

II. Is a method of cost accounting that looks at the impact that

varying levels of costs and volume have on operating profit?

III. A component that calculate the target income?

IV. A calculation that determines the proportion of each product a

business sells relative to total sales.

V. They uses company's sales mix to determine the company's

prospects for overall growth and profitability.

VI. It is a technique for studying the relationship among fixed

costs, variable costs, sales volume, and profits.

VII. It aids in determining what percentage of a company's overall

costs are made up of fixed and variable costs, as well as
measuring a company's effectivity utilizing fixed cost items.

VIII. Involves the use of fixed cost financing

IX. The break-even point is the (1)____ level where (2)___ is the
same for two (or more) alternatives.

X. How is Combining Operating and Financial Leverage calculated?

Answers:

Cost- Volume- Profit Analysis

Changes in Net income
Sales Mix
Analysts and Investors
Break even analysis
Operating leverage
Financial Leverage
EBIT, EPS
Combining Operating and Financial Leverage

II. ESSAY
How can operating and financing leverage benefit a business?

If a business or a company is already experiencing insolvency, is it

better to lever their investments again or must invest to other
company and start a new business?
Is any type of leverage is accurate to calculate and determine the
state of a business if it is refers to high profits due to fixed
costs? Even if it includes fixed operating expenses with fixed
financial expenses and it indicates leverage benefits and risks which
are in fixed quantity?