leverage

Examples of leverage in the following topics:

• Combining Operating Leverage and Financial Leverage

  • To calculate total leverage, we multiply Degree of Operating Leverage by Degree of Financial Leverage.
  • 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.
  • Total leverage can be determined by a couple of different methods.
  • Another way to determine total leverage is by multiplying the Degree of Operating Leverage and the Degree of Financial Leverage.
  • TL = Total Leverage.

• Impacts of Financial Leverage

  • At an ideal level of financial leverage, a company's return on equity increases because the use of leverage increases stock volatility, increasing its level of risk which in turn increases returns.
  • However, if a company is financially over-leveraged a decrease in return on equity could occur.
  • The most obvious risk of leverage is that it multiplies losses.
  • On the other hand, when debt is taken on for personal use there is no value being created, i.e., no leveraging.
  • There is also a misconception that companies enter a higher level of financial leverage out of desperation, referred to as involuntary leverage.

• Defining Operating Leverage

  • Operating leverage is a measure of how revenue growth translates into growth in operating income.
  • Therefore, companies with low output would not benefit from increased operating leverage.
  • Therefore, operating leverage is used much more than financial leverage for these types of firms.
  • Operating leverage also increases forecasting risk.
  • Various measures can be used to interpret operating leverage.

• Benefits and Risks of Operating Leverage

  • Leverage, in general, can defined as any technique that is used to multiply gains and losses.
  • By this definition the use of leverage creates risk, and thus will always necessitate a tradeoff between risk and return.
  • In other words, a company with higher operating leverage has the potential to generate much larger profits than a company with lower operating leverage.
  • Just as the use of operating leverage can lead to greater profits, if a company is able to reach a given, break-even point, so too can the use of leverage drastically multiply losses if that point is not reached.
  • Identify the types of companies that would benefit from higher operating leverage

• Defining Financial Leverage

  • At its simplest, leverage is a tactic geared at multiplying gains and losses.
  • The standard definition of financial leverage is as follows:
  • In short, the ratio between debt and equity is a strong sign of leverage.
  • This results in a financial leverage calculation of 40/60, or 0.6667.
  • Before Lehman Brothers went bankrupt, they were leveraged at over 30 times ($691 billion in financial leverage compared to $22 billion in assets).

• Leverage Models

  • Models that allow us to interpret appropriate financial leverage include the Modigliani-Miller theorem and the Degree of Financial Leverage.
  • Further, value may be added by utilizing leverage.
  • Financial leverage can be measured, or defined, using certain ratios.
  • The higher the Degree of Financial Leverage, the riskier the business.
  • Financial leverage is defined as the ratio of operating income to net income.

• Leverage Models

  • The relationship between fixed and variable costs, when calculated alongside sales volume, enables modeling of operational leverage.
  • Before learning each calculation, it's useful to frame the issue of leverage first.
  • Operating leverage is largely predicated on fixed costs.
  • Most of the calculations and models for leverage are relatively intuitive when looking at examples.
  • At the core of degree of operating leverage is the same concept discussed in the example above.

• Types of Private Financing Deals: Going Private and Leveraged Buyouts

  • A leveraged buyout (LBO) is an acquisition (usually of a company, but it can also be single assets like a real estate) where the purchase price is financed through a combination of equity and debt, and in which the cash flows or assets of the target are used to secure and repay the debt .
  • The debt thus effectively serves as a lever to increase returns, which explains the origin of the term leveraged buyout (LBO).
  • As financial sponsors increase their returns by employing a very high leverage (i.e., a high ratio of debt to equity), they have an incentive to employ as much debt as possible to finance an acquisition.
  • LBOs have become attractive, as they usually represent a win-win situation for the financial sponsor and the banks: The financial sponsor can increase the returns on his equity by employing the leverage; banks can make substantially higher margins when supporting the financing of LBOs as compared to usual corporate lending.

• The DuPont Equation

  • The DuPont equation is an expression which breaks return on equity down into three parts: profit margin, asset turnover, and leverage.
  • Financial Leverage = 5,000,000/10,000,000 = 50%.
  • Under DuPont analysis, return on equity is equal to the profit margin multiplied by asset turnover multiplied by financial leverage.
  • While a high level of leverage could be seen as too risky from some perspectives, DuPont analysis enables third parties to compare that leverage with other financial elements that can determine a company's return on equity.
  • In the DuPont equation, ROE is equal to profit margin multiplied by asset turnover multiplied by financial leverage.

• Break-Even Analysis

  • Recall that operating leverage describes the relationship between fixed and variable costs.
  • Having high operating leverage (having a larger proportion of fixed costs compared to variable costs) can lead to much higher profits for a company.
  • However, increasing operating leverage can also cause substantial losses and puts more pressure on a business.
  • The key to understanding the appropriate amount of operating leverage lies in analysis of the break-even point.
  • By providing a better understanding of the amount of success an investment or project must attain, break-even analysis gives companies a benchmark to compare to and an idea about what level of operating leverage will be ideal to generate greater profits.