BUS601: Financial Management

The percentage change in the earnings before interest and taxes relative to a given percentage change in sales is defined as Operational Leverage.

Degree of Operating Leverage (DOL) = % change in EBIT/% change in sales.

The equation can also be written as follows:

DOL = Contribution/EBIT

If the fixed costs are 0, then the resulting figure will be equal to one. In such a situation contribution and Earnings before Interest and Tax (EBIT) both will be equal. A DOL factor of 1.2 implies that the operating profit will change by 12% for every 10% change in sales (all other things being equal).

The percentage change in Earnings per Share (EPS) due to a given percentage change in EBIT is known as Financial Leverage.

Degree of Financial Leverage (DFL) = % change in EPS/% change in EBIT The following equation can also be used to calculate DFL:

DFL = EBIT/PBT

The ability of a business to use fixed financial charges to magnify the effects of changes in EBIT on the EPS and profits is referred to as financial leverage. It involves the use of funds obtained at a fixed cost with a view to increase the earnings available to the shareholders in future. A DFL factor of 2.3 implies that the EBIT will change by 23% for every 10% change in Profit before Tax (all other things being equal).

Total leverage can be calculated as follows:

 Degree of Total Leverage (DTL) = DOL x DFL

Or

DTL = % change in EPS/% change in sales

Wide fluctuations in EPS for a given change in sales are caused by operating and financial leverage together. As it can be seen from the equation that the total leverage is the outcome of the multiplication of operating leverage and financial leverage. A total leverage of 1.2 x 2.3 = 2.76 indicates that the profit before tax will change by 27.6% for every 10% change in sales.