The concept of operating leverage is closely related to the company's cost structure. Operating leverage or production leverage(leverage) is a mechanism for managing the company's profit, based on improving the ratio of constant and variable costs.
With its help, you can plan changes in the organization’s profit depending on changes in sales volume, as well as determine the break-even point. A necessary condition The application of the operating leverage mechanism is the use of the marginal method, based on dividing costs into fixed and variable. The lower specific gravity fixed costs in the total amount of expenses of the enterprise, the more the amount of profit changes in relation to the rate of change in the company's revenue.
As we know, there are two types of costs in an enterprise: variables and constants. Their structure as a whole, and in particular the level of fixed costs in the total revenue of the enterprise or in revenue per unit of production, can significantly influence the trend in profit or costs. This is due to the fact that each additional unit of production brings some additional profit, which goes to cover fixed costs, and depending on the ratio of fixed and variable costs in the company’s cost structure, the overall increase in income from an additional unit of goods can be significant sudden change arrived. Once the break-even level is reached, profits appear and begin to grow faster than sales.
Operating leverage is a tool for determining and analyzing this relationship. In other words, it is intended to establish the impact of profit on changes in sales volume. The essence of its action is that with an increase in revenue, a greater growth rate of profit is observed, but this greater growth rate is limited by the ratio of fixed and variable costs. The lower the share of fixed costs, the lower this limitation will be.
Production (operating) leverage is quantitatively characterized by the ratio between fixed and variable expenses in their total amount and the value of the indicator “Earnings before interest and taxes”. Knowing the production lever, you can predict changes in profit when revenue changes. There are price levers and natural price levers.
Price operating (production) lever
Price operating leverage (Pc) is calculated using the formula:
Rc = V/P
Where,
B - sales revenue;
P - profit from sales.
Considering that V = P + Zper + Zpost, the formula for calculating price operating leverage can be written as:
Rts = (P + Zper + Zpost)/P = 1 + Zper/P + Zper/P
Where,
Zper - variable costs;
Postage - fixed costs.
Natural operating (production) leverage
Natural operating leverage (RN) is calculated using the formula:
Rn = (V-Zper)/P = (P + Zpost)/P = 1 + Zpost/P Where,
B - sales revenue;
P - profit from sales;
Zper - variable costs;
Postage - fixed costs.
Operating leverage is not measured as a percentage because it is the ratio of contribution margin to sales profit. And since marginal income, in addition to profit from sales, also contains the amount of fixed costs, the operating leverage is always greater than one.
Size operating leverage can be considered an indicator of the riskiness of not only the enterprise itself, but also the type of business in which this enterprise is engaged, since the ratio of fixed and variable expenses in general structure costs are a reflection not only of the characteristics of a given enterprise and its accounting policies, but also of the industry characteristics of its activities.
However, consider that a high proportion fixed costs in the cost structure of an enterprise is a negative factor, just as it is impossible to absolute the value of marginal income. An increase in production leverage may indicate an increase in the production capacity of the enterprise, technical re-equipment, and an increase in labor productivity. The profit of an enterprise with a higher level of production leverage is more sensitive to changes in revenue. With a sharp drop in sales, such a business can very quickly “fall” below the break-even level. In other words, an enterprise with more high level production leverage is riskier.
Since operating leverage shows the change in operating profit in response to a change in the company's revenue, and financial leverage characterizes the change in profit before taxes after paying interest on loans and borrowings in response to changes in operating profit, total leverage gives an idea of how much percent the profit before taxes will change after interest is paid when revenue changes by 1%.
So small operating leverage can be strengthened by raising borrowed capital. High operating leverage, on the contrary, can be offset by low financial leverage. With the help of these effective tools - operational and financial leverage - an enterprise can achieve the desired return on invested capital at a controlled level of risk.
In conclusion, we list the tasks that are solved using operating leverage (production leverage):
calculation of the financial result for the organization as a whole, as well as for types of products, works or services based on the “costs - volume - profit” scheme;
determining the production critical point and using it in acceptance management decisions and setting prices for work;
making decisions on additional orders (answering the question: will it lead to additional order to an increase in fixed costs?);
making a decision to stop producing goods or providing services (if the price falls below the level of variable costs);
solving the problem of maximizing profits through a relative reduction in fixed costs;
using a profitability threshold in development production programs, setting prices for goods, works or services.
Let's analyze the operating leverage of an enterprise and its impact on production and economic activities, consider the formulas for calculating price and natural leverage, and use an example to evaluate its assessment.
Operating leverage. Definition
Operating leverage (operating leverage, production leverage) – shows the excess of the growth rate of profit from sales over the growth rate of the enterprise’s revenue. The goal of any enterprise is to increase profits from sales and, accordingly, net profit, which can be used to increase the productivity of the enterprise and its growth. financial efficiency(cost). The use of operating leverage allows you to manage the future profit from sales of an enterprise by planning future revenue. The main factors that influence the volume of revenue are: product price, variable, fixed costs. Therefore, the goal of management is to optimize variable and fixed costs, regulate pricing policies to increase sales profits.
Formula for calculating price and natural operating leverage
|
Formula for calculating price operating leverage |
Formula for calculating natural operating leverage |
 where: Op. leverage p – price operating leverage;Revenue – sales revenue;Net Sales – profit from sales (operating profit);TVC (Total Variable Costs)
– total variable costs; TFC (Total Fixed Costs)
|
 where: Op. leverage n – natural operating leverage;Revenue – sales revenue;Net Sales – profit from sales (operating profit);TFC (Total Fixed Costs) – total fixed costs. |
What does operating leverage show?
Price operating leverage reflects price risk, that is, the impact of price changes on the amount of profit from sales. shows production risk, that is, the variability of sales profits depending on output volumes.
High operating leverage values reflect a significant excess of revenue over sales profit and indicate an increase in fixed and variable costs. Cost increases may occur as a result of:
- Modernization of existing facilities, expansion of production areas, increase in production personnel, introduction of innovations and new technologies.
- A decrease in product sales prices, an ineffective increase in wage costs for low-skilled personnel, an increase in the number of defects, a decrease in the efficiency of the production line, etc. This leads to an inability to provide the required sales volume and ultimately reduces the margin of financial strength.
In other words, any costs in an enterprise can be both effective, increasing the production, scientific, and technological potential of the enterprise, and, on the contrary, inhibiting development.
Operating leverage. How does productivity affect profits?
Operating leverage effect
Operational (production) effect leverage is that changes in a company's revenue have a stronger impact on sales profits.
As we can see from the table above, the main factors influencing the size of operating leverage are variable, fixed costs, and sales profit. Let's take a closer look at these leverage factors.
Fixed costs- costs that do not depend on the volume of production and sales of goods; in practice, these include: rent for production space, wage management personnel, loan interest, unified social tax deductions, depreciation, property taxes, etc.
Variable costs - costs that vary depending on the volume of production and sales of goods, these include costs for: materials, components, raw materials, fuel, etc.
Revenue from sales depends, first of all, on sales volumes and pricing policy of the enterprise.
Operating leverage of the enterprise and financial risks
Operating leverage is directly related to the margin of financial strength of the enterprise through the ratio:
Op. Leverage – operational leverage;
ZPF – margin of financial strength.
With the growth of operating leverage, the margin of financial strength of the enterprise decreases, which brings it closer to the threshold of profitability and inability to ensure sustainable financial development. Therefore, an enterprise needs to constantly monitor its production risks and their impact on financial ones.
Let's look at an example of calculating operating leverage in Excel. To do this, you need to know the following parameters: revenue, profit from sales, fixed and variable costs. As a result, the formula for calculating price and natural operating leverage will be as follows:
Price operating leverage=B4/B5
Natural operating leverage=(B6+B5)/B5
Example of calculating operating leverage in Excel
Based on the price lever, it is possible to evaluate the impact of the enterprise’s pricing policy on the amount of profit from sales, so if the price of products increases by 2%, the profit from sales will increase by 10%. And with an increase in production volumes by 2%, sales profit will increase by 3.5%. The opposite is similar, as prices and volumes decrease, the resulting value of profit from sales will decrease in accordance with the leverage.
Summary
In this article, we examined the operational (production) lever, which allows us to evaluate sales profits depending on the pricing and production policy of the enterprise. High leverage values increase the risk of a sharp reduction in the enterprise's profit in an unfavorable economic situation, which can ultimately bring the enterprise closer to the break-even point, when profits are equal to losses.
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Operating leverage, while helping to increase profits, simultaneously increases risks - instability of profits and higher critical profitability.
Operating leverage is used by managers to balance different kinds costs and increase income accordingly.
Operating leverage makes it possible to increase profits when the ratio of variable and fixed costs changes. Increase in operating leverage, i.e. An increase in the share of fixed costs leads to an increase in profits.
Operating leverage makes it possible to increase profits when the ratio of variable and fixed costs changes.
Operating leverage can increase profits. However, to obtain benefits, the company must accept certain risks, namely, instability of profits and higher critical profitability.
Operating leverage is characterized by the ratio between fixed and variable expenses in their total amount. If the proportion of fixed expenses is high, the company is said to have a high level of operating leverage. So, the variability of sales profit due to changes in operating leverage quantifies production risk.
The effect of operating leverage is stable only in the short term. This is determined by the fact that operating costs, classified as fixed costs, remain unchanged only for a short period of time. As soon as, in the process of increasing the volume of product sales, another jump in the amount of fixed operating costs occurs, the enterprise needs to overcome the new break-even point or adapt its operating activities to it. In other words, after such a jump, which causes a change in the operating leverage ratio, its effect no - new manifests itself in new business conditions.
The mechanism of operating leverage also has the opposite direction - with any decrease in the volume of product sales, the amount of gross operating profit will decrease to an even greater extent. Moreover, the proportions of such a decrease depend on the value of the operating leverage ratio: the higher this value, the faster the amount of gross operating profit will decrease. operating profit in relation to the rate of decline in product sales. Likewise, as you approach the break-even point in the opposite direction, the negative effect of the rate of decline in profits relative to the rate of decline in product sales will increase. The proportionality of the decrease or increase in the effect of operating leverage with a constant value of its coefficient allows us to conclude that the operational leverage ratio is a tool that equalizes the ratio of the level of profitability and the level of risk in the process of carrying out operating activities.
The effect of operating leverage is stable only in the short term. This is determined by the fact that operating costs, classified as fixed costs, remain unchanged only for a short period of time. As soon as, in the process of increasing the volume of product sales, another jump in the amount of fixed operating costs occurs, the enterprise needs to overcome the new break-even point or adapt its operating activities to it. In other words, after such a jump, which causes a change in the operating leverage ratio, its effect manifests itself in a new way in new business conditions.
The level of operating leverage, calculated as the ratio of semi-fixed costs to total costs, is twice as high in company B compared to company A.
The mechanism of operating leverage also has the opposite direction - with any decrease in the volume of product sales, the size of the gross operating profit will decrease to an even greater extent.
Operating leverage can be managed by influencing both fixed and variable operating costs.
Production or operating leverage is characterized by the relationship between sales revenue and sales profit. There is a multifaceted relationship between these indicators. An increase in revenue can be accompanied by both an increase and a decrease in profits. The study of factors influencing the increase in profit from the conditions for generating revenue relates to the field of application of industrial leverage.
What is operating leverage and what does it characterize?
The positive impact of operating leverage begins to appear only after the company has passed the break-even point of its operating activities. This is due to the fact that the enterprise is obliged to reimburse its fixed operating costs regardless of the specific volume of product sales, therefore, the higher the amount of fixed costs and the operating leverage ratio, the later, other things being equal, it will reach the break-even point of its activities.
Introduction………………………………………………………………………………...4
1 Theoretical foundations of operational and financial leverage…………...….5
1.1 Production and financial risk, relationship between leverage and risk………..5
1.2 The concept of operating leverage, methods for its assessment……….........………7
1.3 The essence and methods of measuring financial leverage…........….……….11
2 Assessment of the operational and financial leverage of an enterprise (using the example of OJSC Primorsky Confectioner).………………………..……………………….………17
2.1 Brief description of the enterprise…………..…………..………………...17
2.2 Calculation of the main indicators of operational analysis................................……21
2.3 Assessment of the financial leverage of the enterprise……...…………………...……31
3 Measures to improve the financial and economic performance of the enterprise (using the example of OJSC Primorsky Confectioner)………………………………………….....35
4 Conclusion………………………………………………………………………………….39
5 References…………………………………………………………………………………41
INTRODUCTION
The creation and operation of any commercial organization is carried out with the aim of making profit, which is the main driving force market economy. It ensures the interests of the state, owners and personnel of the enterprise.
Relevance of the topic is determined by the fact that competent, effective management of the formation of the final financial result involves the construction at the enterprise of appropriate organizational and methodological systems for ensuring this management, knowledge of the basic mechanisms of profit generation, and the use of modern methods of its analysis and planning. One of the main mechanisms for achieving this task is financial and operational leverage. The purpose of the course work is study the mechanism of operational and financial leverage of an enterprise (using the example of OJSC Primorsky Confectioner).
To achieve this goal, it is necessary to consistently solve the following tasks:
Study methods for assessing production and financial leverage;
Assess the level of financial and production leverage of the enterprise, identify the role of these indicators in generating financial results (using the example of OJSC Primorsky Confectioner);
To propose measures to improve the efficiency of an enterprise by managing the level of operational and financial leverage (using the example of OJSC Primorsky Confectioner).
An object research is open Joint-Stock Company"Primorsky confectioner"
Subject The research is operational and financial leverage, cost and capital structure of OJSC Primorsky Confectioner.
1 THEORETICAL BASIS OF OPERATING AND FINANCIAL LEVERAGE
1.1 Production and financial risk, leverage-risk relationship
The current activities of any enterprise are associated with risks, in particular production and financial, which should be taken into account depending on the position from which the enterprise is characterized. As is easy to see from the balance sheet, this characteristic can be performed either from the position of assets owned and managed by the enterprise, or from the position of sources of funds. In the first case, the concept of production risk arises, in the second - financial risk.
Quantitative assessment of risk and the factors that determined it is carried out on the basis of an analysis of profit variability. In financial terms, the relationship between profit and the valuation of the costs of assets or funds incurred to obtain this profit is characterized by the indicator “leverage”. In its literal sense, leverage means “...the action of a small force (lever), with the help of which fairly heavy objects can be moved. When applied to economics, it is interpreted as a certain factor, a small change in which can lead to a significant change in a number of performance indicators.”
The main indicator characterizing the activity of an enterprise is profit, which depends on many factors, so various factor decompositions of its changes are possible. In particular, it can be represented “... as the difference between revenue and expenses of two main types - production and financial. They are not interchangeable, however, the amount and share of each of these types of expenses can be controlled.”
"Industrial risk- this is a risk caused volume and structure of fixed and working capital, in which the company has decided to invest its capital."
The main elements of product cost are variable and fixed costs, and the relationship between them can be different and is determined by the technical and technological policy chosen by the enterprise.
An increase in investments in fixed assets entails an increase in fixed expenses, and an increase in variable expenses in working assets. By managing the amount of these expenses you can significantly influence the amount of profit. This influence is characterized category of production, or operational,leverage, the level of which determines the amount of production risk associated with the company. “The risk manifests itself in the fact that an enterprise with high operating leverage, i.e. with a significant share of fixed costs in the cost structure faces larger fluctuations in profits than an enterprise with low leverage.”
The risk caused by the structure of funding sources is called financial . In this case we're talking about about the ratio of borrowed and equity funds. This ratio is characterized by the category financial leverage. The higher it is, the higher the level of financial leverage. The use of borrowed funds is associated with certain, sometimes significant, costs for a commercial organization. They increase as the share of borrowed capital in the overall structure of financing sources increases and reduce taxable profit. Raising borrowed funds is cheaper than raising your own, but unlike dividends, the payment of which owners can wait for, interest on borrowed capital must be paid in any case, regardless of the final financial result of the enterprise. It is necessary to ensure that the profit received is sufficient to pay interest.
So, the risk of an enterprise is characterized from two sides - assets and liabilities. The structure of assets determines the level of operating leverage, the structure of liabilities affects the level of financial leverage. The use of these mechanisms allows you to more effectively manage the company's financial resources.
1.2 The concept of operating leverage, methods for its assessment
Operating leverage or production leverage is a mechanism for managing the profit of an enterprise, based on optimizing the ratio of fixed and variable costs. With its help, you can predict changes in the profit of an enterprise depending on changes in sales volume, as well as determine the break-even point. The division of enterprise costs into fixed and variable is carried out using the marginal approach. The higher the share of fixed costs in the total costs of the enterprise, the more the amount of profit changes in relation to the rate of change in the enterprise's revenue. Operating leverage is a tool for determining and analyzing this relationship.
Kovalev V.V. gives following definition this concept: “Production leverage is the ability to influence gross income by changing the cost structure and output volume.”
According to Kreinina M.M. operational leverage is “...an indicator of the ratio of sales revenue and sales profit, which characterizes the degree of risk of an enterprise when sales revenue decreases.”
Stoyanova E.S. defines the concept of production leverage as follows: “The action of operational (production, economic) leverage is manifested in the fact that any change in sales revenue always generates a stronger change in profit.”
Operating leverage characterizes the relationship between sales volume, earnings before interest and taxes, and production expenses. The analysis of these relationships consists of quantifying the level of leverage. It is expressed through operational analysis aimed at finding the most profitable combinations between variable costs per unit, fixed costs, price and sales volume. This analysis is based on dividing costs into fixed, variable and mixed.
“There are three methods of cost differentiation:
Maximum and minimum point method;
Graphic;
Least square method" .
The main quantities used in operational analysis are: gross margin (coverage amount), strength of operating leverage, profitability threshold (break-even point), margin of financial strength. Gross margin (coverage amount) is calculated as the difference between sales revenue and variable costs. It shows whether the company has enough funds to cover fixed costs and make a profit. " Operating leverage force calculated as the ratio of gross margin to profit after interest but before income tax:
EOR=VM/P, (1)
EOR – operating leverage effect;
VM – gross margin;
P – profit after paying interest, but before paying income tax.”
Using this formula, you can determine how much profit will change if revenue changes by 1%. The effect of operating leverage is that a change in sales revenue (expressed as a percentage) always leads to a larger change in profit (expressed as a percentage). This effect is associated with the disproportionate impact of semi-fixed and semi-variable costs on the financial result when the volume of production and sales changes. " Profitability threshold (break-even point ) - this is an indicator characterizing the volume of product sales, at which the enterprise’s revenue from the sale of products (works, services) is equal to all its total costs. This is the sales volume at which the business entity has neither profit nor loss. It is calculated using the following formula:
PR=P post /VM relative to revenue, (2)
R post – fixed costs;
VM relative to revenue - gross margin in relative terms to revenue, i.e. this is the ratio of gross margin and revenue."
The volume of production (sales) at the break-even point is called the threshold (critical) volume of production (sales). If a company sells products less than the threshold sales volume, then it suffers losses; if it sells more, it makes a profit. Knowing the profitability threshold, you can calculate the critical production volume:
V cr = PR/C unit, (3)
V cr – critical volume of production in physical terms;
PR – profitability threshold in value terms;
C ed – unit price.
"Margin of financial strength this is the difference between the company's revenue and the profitability threshold. The margin of financial strength shows by what amount revenue can decrease so that the company still does not incur losses. The higher the influence of operating leverage, the lower the margin of financial strength.”
| The concept of operating leverage is closely related to the company's cost structure. Operating leverage or production leverage (leverage) is a mechanism for managing a company's profit, based on improving the ratio of fixed and variable costs. Using it, you can plan changes in the organization’s profit based on changes in sales volume, as well as determine the break-even point. A necessary condition for using the operating leverage mechanism is the use of the marginal method, based on dividing costs into fixed and variable. The lower the share of fixed costs in the total cost of the enterprise, the more the profit changes in relation to the rate of change in the company's revenue. As we know, there are two types of costs in an enterprise: variables and constants . Their structure as a whole, and in particular the level of fixed costs in the total revenue of the enterprise or in revenue per unit of production, can significantly influence the trend in profit or costs. This is due to the fact that each additional unit of production brings in some additional profitability, which goes towards covering fixed costs, and based on the ratio of fixed and variable costs in the company's cost structure, the overall increase in income from an additional unit of goods can be expressed in a significant sharp change arrived. Once the break-even level is reached, profits appear and begin to grow faster than sales volume. Operating leverage is a tool for determining and analyzing this relationship. In other words, it is intended to establish the impact of profit on changes in sales volume. The essence of its action is essentially that with an increase in revenue, a greater growth rate of profit is observed, but this greater growth rate is limited by the ratio of fixed and variable costs. The lower the share of fixed costs, the lower this limitation will be. Production (operating) leverage is quantitatively characterized by the ratio between fixed and variable expenses in their total amount and the value of the indicator “Earnings before interest and taxes”. Knowing the production lever, you can predict changes in profit when revenue changes. There are price and natural price leverage. Price operating (production) leverage Price operating leverage (Рз) is calculated by the formula: Рс = В/П where, В – sales revenue; P – profit from sales. Considering that B = P + Zper + Zpost, the formula for calculating the price operating leverage can be written as: Rts = (P + Zper + Zpost)/P = 1 + Zper/P + Zpost/P where, Zper – variable costs; Postage – fixed costs. Natural operating (production) leverage Natural operating leverage (Рн) is calculated by the formula: Рн = (В-Зр)/П = (П + Зпс)/П = 1 + Зпс/П where, В – sales revenue; P – profit from sales; Zper – variable costs; Postage – fixed costs. Operating leverage is not measured as a percentage because it is the ratio of contribution margin to sales profit. And since marginal income, in addition to profit from sales, also contains the amount of fixed costs, the operating leverage is always greater than one. The amount of operating leverage can be considered an indicator of the riskiness of not only the enterprise itself, but also the type of business in which this enterprise is engaged, since the ratio of fixed and variable expenses in the overall cost structure is a reflection not only of the characteristics of a given enterprise and its accounting policies, but also of industry characteristics activities. At the same time, it is impossible to assume that a high share of fixed expenses in the cost structure of an enterprise is a negative factor, just as it is impossible to absolutize the value of marginal income. An increase in production leverage may indicate an increase in the production capacity of the enterprise, about technical re-equipment, increasing labor productivity. The profit of an enterprise with a higher level of production leverage is more sensitive to changes in revenue. With a sharp drop in sales, such an enterprise can very quickly “fall” below the break-even level. In other words, a company with a higher level of operational leverage is riskier. Since operating leverage shows the change in operating profit in response to a change in the company's revenue, and financial leverage characterizes the change in profit before taxes after paying interest on loans and borrowings in response to changes in operating profit, total leverage gives an idea of how much percent the profit before taxes will change after interest is paid when revenue changes by 1%. However, a small operating leverage can be strengthened by attracting debt capital. High operating leverage, on the contrary, can be leveled out with low financial leverage. With the help of these effective tools - operational and financial leverage - an enterprise can achieve the desired return on invested capital at a controlled level of risk. In conclusion, we list the tasks that are solved with the help of operating leverage: 1. calculation of the financial result for the organization as a whole, as well as by type of product, work or service based on the “costs – volume – profit” scheme; 2. determining the critical point of production and using it when making management decisions and setting prices for work; 3. making decisions on additional orders (answering the question: will an additional order lead to an increase in fixed costs?); 4. making a decision to stop producing goods or providing services (if the price falls below the level of variable costs); 5. solving the problem of profit maximization due to the relative reduction of fixed costs; 6. use of the profitability threshold when developing production programs, setting prices for goods, work or services. |
Financial and operational leverage
The concept of “leverage” comes from the English “leverage” - the action of leverage, and means the ratio of one value to another, with a slight change in which the indicators associated with it change greatly.
The most common types of leverage are:
· Production (operational) leverage.
All companies use financial leverage to some degree. The whole question is what is the reasonable ratio between equity and debt capital.
Financial leverage ratio(leverage) is defined as the ratio of debt to equity capital. It is most correct to calculate it according to market valuation assets.
The effect of financial leverage is also calculated:
EGF = (1 - Kn)*(ROA - Tsk) * ZK/SK.
· where ROA is the return on total capital before taxes (the ratio of gross profit to average asset value), %;
· SK - average annual amount of equity capital;
Kn - taxation coefficient, in the form decimal;
· Tsk - weighted average price of borrowed capital, %;
· ZK - average annual amount of borrowed capital.
The formula for calculating the effect of financial leverage contains three factors:
· (1 - Kn) - does not depend on the enterprise.
· (ROA - Tsk) - the difference between return on assets and the interest rate for the loan. It is called differential (D).
· (ZK/SC) - financial leverage (FL).
You can write the formula for the effect of financial leverage in short:
EGF = (1 - Kn) ? D? FR.
The effect of financial leverage shows by what percentage the return on equity increases due to the attraction of borrowed funds. The effect of financial leverage occurs due to the difference between return on assets and the cost of borrowed funds. The recommended EGF value is 0.33 - 0.5.
The resulting effect of financial leverage is essentially that the use of debt, all other things being equal, leads to the fact that the growth of corporate earnings before interest and taxes leads to a stronger increase in earnings per share.
The effect of financial leverage is also calculated taking into account the effects of inflation (debts and interest on them are not indexed). As the inflation rate increases, the fee for using borrowed funds becomes lower (interest rates are fixed) and the result from their use is higher. Moreover, if interest rates are high or the return on assets is low, financial leverage begins to work against the owners.
Leverage is a very risky business for those enterprises whose activities are cyclical in nature.
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As a result, several consecutive years of low sales can push highly leveraged businesses into bankruptcy.
For more detailed analysis changes in the value of the financial leverage ratio and the factors that influenced it use the 5-factor analysis of the financial leverage ratio.
Moreover, financial leverage reflects the degree of dependence of the enterprise on creditors, that is, the magnitude of the risk of loss of solvency. In addition, the company has the opportunity to take advantage of the “tax shield”, since, unlike dividends on shares, the amount of interest on the loan is deducted from the total profit subject to taxation.
Operating leverage (operating leverage) shows how many times the rate of change in sales profit exceeds the rate of change in sales revenue. Knowing the operating leverage, you can predict changes in profit when revenue changes.
It is the ratio of a company's fixed to variable expenses and the effect that ratio has on earnings before interest and taxes (operating profit). Operating leverage shows by what percentage profit will change if revenue changes by 1%.
Price operating leverage is calculated using the formula:
Rts = (P + Zper + Zpost)/P =1 + Zper/P + Zper/P
· where: B - sales revenue.
· P - profit from sales.
· Zper - variable costs.
· Postage - fixed costs.
· РЦ - price operating leverᴦ.
· RN - natural operating leverage.
Natural operating leverage is calculated using the formula:
Rn = (V-Zper)/P
Considering that B = P + Zper + Zpost, we can write:
Рн = (P + Zpost)/P = 1 + Zpost/P
Operating leverage is used by managers to balance various types of costs and increase revenue accordingly. Operating leverage makes it possible to increase profits when the ratio of variable and fixed costs changes.
The position that fixed costs remain unchanged when production volume changes, and variable costs increase linearly, allows us to significantly simplify the analysis of operating leverage. But it is known that real dependencies are more complex.
With an increase in production volume, variable costs per unit of output can either decrease (the use of progressive technological processes, improving the organization of production and labor) and increase (increasing losses due to defects, decreasing labor productivity, etc.). Revenue growth rates are slowing down due to lower product prices as the market becomes saturated.
Financial leverage and operating leverage are similar methods. As with operating leverage, financial leverage increases fixed costs in the form of high interest payments on loans, but because lenders do not share in the company's earnings, variable costs are reduced. Accordingly, increased financial leverage also has a two-fold effect: more operating income is required to cover fixed financial costs, but once cost recovery is achieved, profits begin to grow faster with each additional unit of operating income.
The combined influence of operating and financial leverage is known as the common lever and is their product:
Total leverage = OL x FL
This indicator gives an idea of how changes in sales will affect changes in net profit and earnings per share of the company. In other words, it will allow you to determine by what percentage the change net profit when sales volume changes by 1%.
For this reason, production and financial risks multiply and form the total risk of the enterprise.
However, both financial and operating leverage, both potentially effective, can be very dangerous due to the risks they contain. The trick, or rather good financial management, is to balance these two elements.
9. Financial management - as a management system
Industrial (operational) leverage - concept and types. Classification and features of the category "Production (operational) leverage" 2017, 2018.
