CHAPTER 4
MEASURES OF LEVERAGE
LEARNING OUTCOMES
After completing this chapter, you will be able to do the following:
- Define and explain leverage, business risk, sales risk, operating risk, and financial risk and classify a risk, given a description.
- Calculate and interpret the degree of operating leverage, the degree of financial leverage, and the degree of total leverage.
- Describe the effect of financial leverage on a company’s net income and return on equity.
- Calculate the breakeven quantity of sales and determine the company’s net income at various sales levels.
- Calculate and interpret the operating breakeven quantity of sales.
1. INTRODUCTION
This chapter presents elementary topics in leverage. Leverage is the use of fixed costs in a company’s cost structure. The fixed costs that are operating costs (such as depreciation or rent) create operating leverage. Fixed costs that are financial costs (such as interest expense) create financial leverage.
Analysts refer to the use of fixed costs as leverage because these fixed costs act as a fulcrum for the company’s earnings. Leverage can magnify earnings both up and down. The profits of highly leveraged companies might soar with small upturns in revenue. But the reverse is also true: Small downturns in revenue may lead to losses.
Analysts need ...
