Financial and Other Leverage

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Presentation transcript:

Financial and Other Leverage Presentation Chapter 5 Financial and Other Leverage

Operating Leverage Changes in revenues produce greater changes in operating income. Degree is related to fixed costs. Above B/E, all marginal contribution becomes operating income. Greatest leverage near B/E where small change in sales has the opposite effect on profits.

Financial Leverage When both of the following exist: Limited Cost Securities. Debt with fixed or variable rate of interest. ROI Is Not Equal to Cost of Debt. The firm's ROI must not be equal to the interest rate.

Financial Leverage Impact Three situations: ROI Is Greater than Interest Rate. Firm has favorable financial leverage. ROI Equals Interest Rate. No leverage. ROI Is Less than Interest Rate. Unfavorable financial leverage.

Profitability Ratios These measure the short-term (One year) success or failure. EBIT (also called Operating income) Net income. Level of sales and assets Costs.

Profit Margin Formula: Compares profit to the level of sales. High Ratio. Profit on sales provides adequate return to investors. Low Ratio. Profit on sales is inadequate.

Asset Turnover Formula: Revenues/Total Assets Compares revenues to assets. Low Ratio. May show idle or inefficient assets. High Ratio. May show efficient use of assets.

Return on Investment Formula: EBIT/Total Assets Compare profit to assets. High Ratio. May show acceptable return from assets. Low Ratio. May show unacceptable return from assets.

Question What happens if we multiply profit margin by asset turnover? PM = EBIT/Revenues AT = Revenues/Total Assets

Answer We get ROI. EBIT x Sales Sales Assets

Question What is the weaknesses of profit margin?

Answer Profit margin ignores the level of assets. Revenues may be too small to provide adequate profits on a large asset base.

Question What is the weaknesses of asset turnover?

Answer Asset turnover ignores profits. Sales may be high compared to assets but may not produce an adequate profit.

Return on Equity Formula: Net Income/Total Equity Compares after-tax profit with invested capital. High Ratio. May show adequate return on capital invested by owners. Low Ratio. May show inadequate return.

Question A firm has a high return on investment but a low return on equity. How can this happen?

Answer The differences between ROI and ROE are: Interest paid on debt. Taxes.

Question What are the possible causes (not symptoms) of a low return on equity?

Answer (1) Possible causes affecting ROI: Low Prices. Affects profit margin. High Costs. Affects profit margin. Excessive Assets. Affects asset turnover. Low Sales Volume. Affects asset turnover. .

Answer (2) Possible causes affecting ROE: High Interest Rates. Affects ROE. High Debt Level. Affects ROE. High Taxes. Affects ROE.