Fixed commitments magnify everything
Some costs are fixed no matter how much you sell; some obligations, like interest, are fixed no matter how much you earn. Both create leverage: a small change in sales produces a larger change in profit, in either direction.
Operating leverage comes from fixed operating costs such as rent, salaries, and depreciation. Financial leverage comes from fixed financing costs such as interest. Combined, they determine how violently earnings per share reacts to a change in revenue.
Leverage is not good or bad by itself. It magnifies whatever the business already does. A stable, growing firm can use it to lift returns; a volatile one can be pushed into distress by the same mechanism.
Key points
- Operating leverage is driven by fixed operating costs.
- Financial leverage is driven by interest-bearing debt.
- Both amplify gains and losses symmetrically.
Measuring the magnification
DOL = Contribution ÷ EBIT
How much a change in sales moves operating profit.
DFL = EBIT ÷ (EBIT − Interest)
How much a change in operating profit moves earnings per share.
DCL = DOL × DFL = Contribution ÷ (EBIT − Interest)
The total amplification from sales to earnings per share.
EPS = (EBIT − Interest) × (1 − t) ÷ Shares
Profit available to each share after interest and tax.
Coverage = EBIT ÷ Interest expense
How many times operating profit covers the interest bill.
When EBIT is close to zero, DOL and DFL become very large and unstable. Ratios lose meaning near a loss, which is exactly when the risk is highest.
Nova's leverage at 9,000 units
Nova's contribution is ৳1,845,000 and EBIT is ৳1,065,000, so DOL is 1.73. Interest of ৳313,500 brings profit before tax to ৳751,500, so DFL is ৳1,065,000 ÷ ৳751,500 = 1.42. Combined leverage is 1.73 × 1.42 = 2.46.
A combined leverage of 2.46 means a 10% change in sales moves earnings per share by about 24.6%. Net income is ৳751,500 × 0.75 = ৳563,625, or ৳1.13 per share across 500,000 shares. Interest is covered 3.4 times.
The coverage ratio is the safety margin for lenders. Below about 2 times, a modest earnings fall starts to threaten the interest payment.
Key points
- DOL 1.73, DFL 1.42, DCL 2.46.
- A 10% sales change becomes a ~25% EPS change.
- Interest is covered 3.4 times, a moderate cushion.
Choosing how much leverage to carry
Debt is cheaper than equity and the interest is tax-deductible, so some leverage lowers the cost of capital and raises returns in good times. But it also adds a fixed payment that must be met in bad times, and it raises the risk shareholders bear.
Compare financing plans at more than one profit level. The break-even EBIT between an all-equity plan and a partly debt-funded plan is the point where earnings per share are equal. Above it, debt lifts EPS; below it, debt drags EPS down.
The practical test is resilience: how far can EBIT fall before coverage becomes uncomfortable, and can the business survive a bad year without breaching covenants? Leverage that only works in the base case is not leverage, it is a bet.
Key points
- Debt raises EPS above the break-even EBIT and lowers it below.
- Coverage ratios reveal how much room there is before distress.
- Match leverage to the stability of the cash flows it finances.
Interactive experiment
Operating and financial leverage
Leverage measures how sensitive profit is to a change in sales. Fixed operating costs create operating leverage; debt creates financial leverage.
DCL = DOL × DFL
Your inputs
Volume in the period.
Average selling price.
Direct cost of one unit.
Overheads independent of volume.
Fixed financing cost.
Effective tax rate.
Shares used for EPS.
Result
- EBIT
- ৳1,065,000
- Earnings per share
- ৳1
- Combined leverage (DCL)
- 2.46×
- Contribution
- ৳1,845,000
- Degree of operating leverage
- 1.73×
- Degree of financial leverage
- 1.42×
- Interest coverage
- 3.40×
- Net income
- ৳563,625
Combined leverage of 2.46 means a 10% change in sales moves earnings per share by about 24.6%.
03 / Apply
Financing a factory expansion
Halcyon Works can fund a ৳20,000,000 expansion entirely with equity, or half with debt at 8% interest. Analysts expect EBIT of ৳2,000,000, but a downturn could cut that to ৳800,000. The tax rate is 25%.
The assumptions
- Plan A issues 300,000 new shares, taking the total to 1,000,000, with no interest.
- Plan B issues 150,000 new shares, taking the total to 700,000, and pays ৳400,000 interest.
- EBIT is the same under both plans; only financing differs.
What to take away
01
At EBIT of ৳2,000,000, Plan B gives higher EPS (1.71 vs 1.50).
02
At EBIT of ৳800,000, Plan A gives higher EPS (0.60 vs 0.43).
03
The two plans break even at EBIT of about ৳1,333,333.
Your turn
0 of 4 answered
01Question
Contribution is ৳1,845,000 and EBIT is ৳1,065,000. What is the degree of operating leverage? Round to two decimals.
02Question
EBIT is ৳1,065,000 and interest is ৳313,500. What is the degree of financial leverage? Round to two decimals.
03Question
Profit before tax is ৳751,500, the tax rate is 25%, and there are 500,000 shares. What is earnings per share? Round to two decimals.
04Question
A firm with high combined leverage expects a sales downturn. What does the measurement warn?
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OpenStax · Principles of Finance, Capital Structure chapter ↗Educational sample content. Worked examples use hypothetical figures. Dates refer to the note's latest content update.