Theoretical Background

Leverage refers to the effects that fixed costs have on the returns that shareholders earn. By
fixed costs we mean costs that do not rise and fall with changes in a firms sales. Firms
have to pay these fixed costs whether business conditions are good or bad. These fixed costs
may be operating costs, such as the costs incurred by purchasing and operating plant and
equipment, or they may be financial costs, such as the fixed costs of making debt payments.
Generally, leverage magnifies both returns and risks. A firm with more leverage may earn
higher returns on average than a firm with less leverage, but the returns on the more
leveraged firm will also be more volatile.
Many business risks are out of the control of managers, but not the risks associated with
leverage. Managers can limit the impact of leverage by adopting strategies that rely more
heavily on variable costs than on fixed costs. For example, a basic choice that many firms
confront is whether to make their own products or to outsource manufacturing to another
firm. A company that does its own manufacturing may invest billions in factories around the
world. These factories generate costs whether they are running or not. In contrast, a company
that outsources production can completely eliminate its manufacturing costs simply by not
placing orders. Costs for a firm like this are more variable and will generally rise and fall as
demand warrants.
In the same way, managers can influence leverage in their decisions about how the company
raises money to operate. The amount of leverage in the firms capital structurethe mix of
long-term debt and equity maintained by the firmcan significantly affect its value by
affecting return and risk. The more debt a firm issues, the higher are its debt repayment costs,
and those costs must be paid regardless of how the firms products are selling. Because
leverage can have such a large impact on a firm, the financial manager must understand how
to measure and evaluate leverage, particularly when making capital structure decisions.
(Gitman & Zutter 2011)

Breakdown of Leverage

Operating leverage is concerned with the relationship between the firms sales
revenue and its earnings before interest and taxes (EBIT) or operating profits. When
costs of operations (such as cost of goods sold and operating expenses) are largely
fixed, small changes in revenue will lead to much larger changes in EBIT.
o Degree of Operating Leverage (DOL)
It is a numerical measure of the firms operating leverage.
The formula is: DOL = % change in EBIT / % change in Sales
Whenever the percentage change in EBIT resulting from a
given percentage change in sales is greater than the percentage
change in sales, operating leverage exists. This means that as

long as DOL is greater than 1, there is operating leverage.

Financial leverage is concerned with the relationship between the firms EBIT and its
common stock earnings per share (EPS). On the income statement, you can see that
the deductions taken from EBIT to get to EPS include interest, taxes, and preferred
dividends. Taxes are clearly variable, rising and falling with the firms profits, but
interest expense and preferred dividends are usually fixed. When these fixed items are
large (that is, when the firm has a lot of financial leverage), small changes in EBIT
produce larger changes in EPS.
o Degree of Financial Leverage (DFL)
It is a numerical measure of the firms financial leverage
The formula of DFL = % in EPS / % in EBIT
Whenever the percentage change in EPS resulting from a given
percentage change in EBIT is greater than the percentage
change in EBIT, financial leverage exists. This means that

whenever DFL is greater than 1, there is financial leverage.

Total leverage is the combined effect of operating and financial leverage. It is

concerned with the relationship between the firms sales revenue and EPS. We also
can assess the combined effect of operating and financial leverage on the firms risk
by using a framework similar to that used to develop the individual concepts of
leverage. This combined effect, or total leverage, can be defined as the use of fixed

costs, both operating and financial, to magnify the effects of changes in sales on the
firms earnings per share. Total leverage can therefore be viewed as the total impact of
the fixed costs in the firms operating and financial structure.
o Degree of Total Leverage (DTL)
It is the numerical measure of the firms total leverage.
The formula of DTL = % change in EPS / % Change in Sales
Whenever the percentage change in EPS resulting from a given
percentage change in sales is greater than the percentage
change in sales, total leverage exists. This means that as long as
the DTL is greater than 1, there is total leverage.
o Relationship between Operating and Financial Leverage
Relationship of Operating, Financial, and Total Leverage Total
leverage reflects the combined impact of operating and financial
leverage on the firm. High operating leverage and high financial
leverage will cause total leverage to be high. The opposite will also be
true. The relationship between operating leverage and financial
leverage is multiplicative rather than additive. The relationship
between the degree of total leverage (DTL) and the degrees of
operating leverage (DOL) and financial leverage (DFL) is given by
Equation: DTL = DOL x DFL