Leverage is the extent to which fixed costs are used in a company's cost structure.

**Operating leverage**is the extent to which fixed operating costs (e.g., depreciation, rent) are used in a firm's operations.**Financial leverage**is the extent to which fixed-income securities (debt and preferred stock) are used in a firm's capital structure.

Leverage affects a firm's risk, as it can magnify earnings both up and down. The bigger the leverage, the more volatile the firm's future earnings and cash flows, and the greater the discount rate applied in the firm's valuation (by bondholders and stockholders).

Business risk is the combined risk of sales and operations risks.

- The
**sales risk**is the uncertainty regarding the price and quantity of the firm's goods and services. If the demand for and the price of a firm's goods and services are stable, its sales risk is considered low. - The
**operating risk**is the uncertainty caused by a firm's operating cost structure. If a high percentage of operating costs are fixed costs, operating risk is considered to be high.

In general, management has more opportunity to manage and control operating risk than sales risk.

A company that has high operating leverage is a company with a large proportion of fixed input costs, whereas a company with largely variable input costs is said to have low operating leverage (due to its small amount of fixed costs).

A company with a high degree of operating leverage that has a small change in sales will experience a large change in profits and rate of return. This is due to the fact that because the company has a large fixed cost component, any increase in sales will cause an even greater increase in net income, since the fixed costs have already been incurred.

In many respects operating leverage is determined by technology. High (low) operating leverage is usually associated with capital (labor) intensive industries.

The

Here Q is the number of units, P is the average sales price per unit of output, V is the variable cost per unit, F is fixed operating cost, S is sales in dollars, and VC is total variable costs.

P - V is referred to as the

For example, assume that a firm has sales of $100,000, variable costs of $50,000, and fixed costs of $20,000. Its DOL is (100,000 - 50,000) / (100,000 - 50,000 - 20,000) = 1.67.

johntan1979: DOL: What is considered high and what is low? Is 1.67 (example in the notes) high? |

robertucla: You have to compare dol to comparable firms in industry |

jodyleesc: Can someone explain why %change in EBIT / %change in Sales = Q(P - V) / Q(P-V) - F ? |

khalifa92: those are two different equations to find DOLjohntan higher DOL is caused bu graeter use of fixed operating cost relative to vc leads to more sensitivite in EBIT unit solds thus more risk |

unknown: Jodyleesc: Think about it as elasticity. %change Y / %changeX.By definition, EBIT = Q(P-V)-F and Sales = Q*P; When we do point elasticity, where dx->0, we have %changeY / %changeX = dY/dX * X/Y; if you take derivatives of EBIT and Sales with respect to Quantity, then dY= (P-V) and dX = P; thus (P-V)/P * X/Y = (P-V)/P*(Q*P/EBIT) = (P-V)*Q/EBIT = (P-V)*Q/ ((P-V)*Q-F) |

MathLoser: @Jodyleesc:First: Calculate DOL using [Q(P-V)] / [Q(P-V)-F] Example: you have DOL = 3,0. Assume that your company has a 3% increase in sales. %change in EBIT = DOL x %change in sales = 3 x 3% = 9% That's the point of the formula. |