This is an Assignment done on normal understanding of Operating Leverage, Financial Leverage & Total Leverage, and the relevant calculation formulas and implications.

1. F401 CORPORATE FINANCE
ASSIGNMENT ON ‘OPERATING, FINANCIAL & TOTAL
LEVERAGE’
Prepared for:
Rafia aFRIN
LECTURER
Prepared by:
Sylvia Islam
Roll: RH- 45, Batch: 20
29 APRIL 2015
Institute of Business Administration
University of Dhaka

2. CONTENTS
OPERATING LEVERAGE.................................................................................................................................................................1
Calculation......................................................................................................................................................................................1
Effect on Risk.................................................................................................................................................................................1
FINANCIAL LEVERAGE ..................................................................................................................................................................2
Calculation......................................................................................................................................................................................2
Effect on Risk.................................................................................................................................................................................3
TOTAL LEVERAGE............................................................................................................................................................................3
Implication .....................................................................................................................................................................................4
APPENDIX............................................................................................................................................................................................5

3. ASSIGNMENT ON ‘OPERATING, FINANCIAL & TOTAL LEVERAGE’
1
OPERATING LEVERAGE
The concept of operating leverage helps to measure the degree to which a company is ready to incur a
combination of fixed and variable costs. Operating leverage is a measure of how revenue growth
translates into growth in operating income. The basis of analysis of Operating leverage is the fixed cost
and the variable cost incurred by the company. Operating leverage in a company can only be seen when
they have fixed costs in the company that must be met regardless of sales volume. Fixed costs are those
costs that do not change with the level of sales. Variable costs are those costs that vary directly with the
level of the output being sold. These costs INCLUDE the cost of raw materials, labor expenses and all
those expenses which are incurred to produce a product.
However, the Operating Leverage will always be higher in those companies where there is a high
proportion of fixed operating cost in relation to variable operatingcost. In such companies, there is a lot
of use of fixed assets in the operation of the company.
CALCULATION
The Degree of Operating Leverage (DOL) is the leverage ratio that sums up the effect of an amount of
operating leverage on the company’s earnings before interests and taxes (EBIT). Operating Leverage
takes into account the proportion of fixed costs to variable costs in the operations of a business. If the
degree of operating leverage is high, it means that the earnings before interest and taxes would be
unpredictable for the company, even if all the other factors remain the same.
The formula used for determining the Degree of Operating Leverage or DOL is as follows:
EFFECT ON RISK
Business risk is the risk that a company will not have enough cash on hand to pay its bills, also known
as operating expenses. There are many reasons that a company may not be able to pay its bills. If it has
too much debt it may have to pay its bondholders before meeting the demands of other creditors. If it
overspends and its earnings drop, it may not be able to meet its obligations. If it makes a number of
risky investments, or a new product fails, it could lose a large amount of capital, leaving it without the
funds to continue operating. In extreme cases, this can lead to bankruptcy.

4. ASSIGNMENT ON ‘OPERATING, FINANCIAL & TOTAL LEVERAGE’
2
Operating leverage and business risk have an obvious relationship. The higher the operating leverage,
the more business risk a company has. This is because if a company that depends on just a handful of
sales lose a client, a large portion of its revenue will be gone, which could leave it unable to pay
creditors. Or, if a company has variable costs and it underestimates how much money it will need
during a fiscal year, it could run short of cash and be unable to pay its bills.
Conversely, those companies with less operating leverage are more stable and less likely to default on
their bills simply because they have a greater ability to forecast their financial situation and see
problems coming much further ahead.
FINANCIAL LEVERAGE
Financial leverage is the acquiring of assets with the funds provided by creditors and preferred
stockholders for the benefit of common stockholders. In other words, financial leverage is the
additional volatility of net income caused by the presence of fixed-cost funds. The potential benefits are
that if operating income is rising net income will rise more quickly. The negative side is that if operating
income is falling net income will fall more quickly, including possibly negative values. Financial leverage
is a two-edged sword. It may be positive or negative.
CALCULATION
Degree of financial leverage (DFL) is defined as the percentage change in earning per share due to one
percent change in the earnings before interest and tax. In other words it shows the impact of fixed
charge on firms earning per share due to change in its earnings before interest and tax. It measures the
percentage change in earnings per share over the percentage change in EBIT. It is the measure of the
sensitivity of EPS to changes in EBIT as a result of changes in debt. The following formulae are used to
calculate DFL:
Degree of Financial Leverage =
or
Degree of financial leverage =

5. ASSIGNMENT ON ‘OPERATING, FINANCIAL & TOTAL LEVERAGE’
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EFFECT ON RISK
The financial leverage ratio measures the amount of debt held by the business firm that it uses to
finance its operations. Debt creates additional business risk to the firm if income varies because debt
has to be serviced. In other words, if a firm uses debt financing, it has to pay interest on the debt no
matter what its income. The financial leverage ratio measures that effect on the business firm. The DFL
helps in calculating the comparative change in net income caused by a change in the capital structure of
business. This ratio would help in determining the fate of net income of the business. This ratio also
helps in determining the suitable financial leverage which is to be used to achieve the business goal. The
higher the leverage of the company, the more risk it has, and a business should try and balance it as
leverage is similar to having a debt.
The degree of financial leverage is useful for figuring out the fate of net income in the future, which is
based on the changes that take place in the interest rates, taxes, operating expenses and other financial
factors. Debts added to a business would provide an interest expense to the company which is a fixed
cost, and this is when the company’s business begins to turn to provide profit. It is important to balance
the financial leverage according to the operating costs of the company as it would minimize the level of
risks involved. Firms that use financial leverage run the risk that their operating income will be
insufficient to cover the fixed charges on debt and/or preferred stock financing. Financial leverage can
become especially burdensome during an economic downturn. Even if a company has sufficient
earnings to cover its fixed financial costs, its returns could be decreased during economically difficult
times due to shareholders' residual claims to dividends.
Generally, if a company's return on assets (profits. total assets) is greater than the pretax cost of debt
(interest percentage), the financial leverage effect will be favorable. The opposite, of course, is also true:
if a company's return on assets is less than its interest cost of debt, the financial leverage effect will
decrease the returns to the common shareholders.
TOTAL LEVERAGE
The two types of leverage explored so far can be combined into an overall measure of leverage called
total leverage. Whereas operating leverage is concerned with the relationship between sales and
operating profits, financial leverage is concerned with the relationship between profits and earnings
per share. Total leverage is therefore concerned with the relationship between sales and earnings per
share. Specifically, it is concerned with the sensitivity of earnings to a given change in sales.

6. ASSIGNMENT ON ‘OPERATING, FINANCIAL & TOTAL LEVERAGE’
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Total leverage is the total amount of risk facing a business firm. It can also be looked at in another way.
It is the total amount of leverage that we can use to magnify the returns from our business. Operating
leverage magnifies the returns from our plant and equipment or fixed assets. Financial leverage
magnifies the returns from our debt financing. Combined leverage is the total of these two types of
leverage or the total magnification of returns. This is looking at leverage from a balance sheet
perspective. It is also helpful and important to look at leverage from an income statement perspective.
Operating leverage influences the top half of the income statement and operating income, determining
return from operations. Financial leverage influences the bottom half of the income statement and the
earnings per share to the stockholders.
The concept of leverage, in general, is used in breakeven analysis and in the development of the capital
structure of a business firm. It’s calculated using the following formula:
IMPLICATION
The degree of total leverage is defined as the percentage change in stockholder earnings for a given
change in sales, and it can be calculated by multiplying a company's degree of operating leverage by its
degree of financial leverage. Consequently, a company with little operating leverage can attain a high
degree of total leverage by using a relatively high amount of debt.
Total risk can be divided into two parts: business risk and financial risk. Business risk refers to the
stability of a company's assets if it uses no debt or preferred stock financing. Business risk stems from
the unpredictable nature of doing business, i.e., the unpredictability of consumer demand for products
and services. As a result, it also involves the uncertainty of long-term profitability. When a company
uses debt or preferred stock financing, additional risk—financial risk—is placed on the company's
common shareholders. They demand a higher expected return for assuming this additional risk, which
in turn, raises a company's costs. Consequently, companies with high degrees of business risk tend to be
financed with relatively low amounts of debt. The opposite also holds: companies with low amounts of
business risk can afford to use more debt financing while keeping total risk at tolerable levels.
Moreover, using debt as leverage is a successful tool during periods of inflation. Debt fails, however, to
provide leverage during periods of deflation, such as the period during the late 1990s brought on by the
Asian financial crisis.

7. ASSIGNMENT ON ‘OPERATING, FINANCIAL & TOTAL LEVERAGE’
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APPENDIX
Gill, K. (n.d.). Corporate Finance: What is the financial leverage effect and what causes it? Retrieved April
2015, from http://www.quora.com: http://www.quora.com/Corporate-Finance/What-is-the-
financial-leverage-effect-and-what-causes-it
James A. Gerhardinger, K. H. (n.d.). LEVERAGE . Retrieved aPRIL 2015, from
www.referenceforbusiness.com: http://www.referenceforbusiness.com/encyclopedia/Kor-
Man/Leverage.html
Mann, T. (n.d.). Retrieved April 29, 2015, from www.ehow.com:
http://www.ehow.com/about_6500377_operating-leverage-business-risk.html
Peavler, R. (n.d.). Business Risk Ratios - How to Calculate Business Risk. Retrieved April 29, 2015, from
http://bizfinance.about.com: http://bizfinance.about.com/od/pricingyourproduct/a/business-
risk-ratios-how-to-calculate-business-risk.htm