Level 1 CFA® Exam:
Leverage

Let's start with the basics.

Leverage increases the volatility of a company’s earnings and cash flows. The greater the company's leverage, the greater its risk and the discount rate used for the company’s valuation.

The company’s cost structure affects the level of leverage. Costs are divided into:

• variable costs and
• fixed costs.

Variable costs are costs that fluctuate with the level of production and sales. These could for example be costs of materials or shipping charges. Fixed costs are not dependent on the level of production and sales, which means that they must be covered irrespective of the number of units sold.

A high level of fixed operating costs makes it difficult to adjust a company’s operating costs to changes in sales and increases operating risk. Notice that cost structure can vary even among companies engaged in similar business activities, and so can operating risk.

What is important in the context of costs is elasticity. It is a measure of the sensitivity of changes in one item to changes in another. The degree of the operating leverage (DOL), which is a measure of operating risk, is based on this concept. DOL is the ratio of the percentage change in operating income to the percentage change in units sold. This is reflected in this formula that you can use in your level 1 CFA exam:

How should we interpret DOL?

If DOL equals 1.3 and sales increase by 4 percent, then the operating profit will grow by \(1.3\times4\%=5.2\%\). Note that if sales didn’t increase but decreased by 4 percent, then the operating profit would fall by 5.2 percent.

An important category of the income statement item here is operating income which can be calculated using this formula:

\(\text{operating income}=Q\times(P-V)-O\)

The operating income equals the product of the number of units sold (\(Q\)) and the difference between the price per unit (\(P\)) and the variable cost per unit (\(V\)) less fixed operating costs (\(O\)).

\(P-V\) - per unit contribution margin,

\(Q\times(P-V)\) - contribution margin,

The following formula helps you with level 1 CFA exam questions where you need to calculate the degree of the operating leverage:

The principle is that when a company has a positive DOL, the DOL decreases when the number of products sold increases. Why is that? Because as the number of products sold increases, the proportion of variable costs, in terms of value, in the structure of total cost increases, too. So, the proportion of the fixed costs in total cost decreases and, as we know, it results in a decrease in operating risk.

What is also important is that in the case of a negative operating profit, the degree of operating leverage will also be negative.

Remember that operating profit is most sensitive to changes in sales volume if sales are close to the operating breakeven point. The operating breakeven point is the number of units sold at which the company's operating income is zero.

Our examples illustrate that the two types of business risk, that is sales risk and operating risk, have a strong impact on a company’s activity and their level is highly dependent on the industry in which the company operates.

However, when it comes to operating risk, the management may control it to a certain extent. Let’s consider a case when a company wants to buy new equipment. Whether a product is made using an old or a modern machine has no effect on the sales volume. However, this new equipment can affect the cost structure, and more specifically, the ratio of fixed costs to variable costs. It is an analyst’s job to forecast how such an operation will influence costs and consequently the company’s operating risk.

Companies that spend most of their funds on research and development of their products but spend relatively little funds on their production and distribution are characterized by a high degree of operating leverage. This is due to a high proportion of fixed costs in the cost structure. Such companies include computer and pharmaceutical companies. The opposite of such companies are companies that generate mainly variable costs which depend on the volume of sales, so the degree of their operating leverage is quite low. These are mainly companies operating in the retail sector.

The degree of total leverage (DTL) is a measure of the sensitivity of net income to changes in the number of units sold by 1%.

The degree of total leverage (DTL) may also be calculated by multiplying the degree of operating leverage (DOL) by the degree of financial leverage (DFL):

1. Leverage increases the volatility of a company’s earnings and cash flows.
2. Variable costs are costs that fluctuate with the level of production and sales.
3. Fixed costs are not dependent on the level of production and sales.
4. Business risk is the risk associated with operating earnings which, in turn, depend on revenues.
5. Sales risk is when the price or quantity of products or services is different than expected. The greater the standard deviation of the number and price of the units sold, the greater the sales risk.
6. Operating risk depends on the ratio of fixed costs to variable costs.
7. In the case of operating leverage, the higher fixed operating costs, the higher sensitivity of operating income to changes in the number of units sold.
8. In the case of financial leverage, the higher fixed financial costs, the higher sensitivity of net income to changes in operating income.
9. Total leverage combines those two effects and tells us how net income will change if the number of units sold rises by 1%.