DOL The Degree of Operating Leverage (DOL) is the leverage ratio that sums up the effect of an amount of operating leverage on the company’s earnings before interests and taxes (EBIT). Operating Leverage takes into account the proportion of fixed costs to variable costs in the operations of a business. If the degree o f operating leverage is high, it means that the earnings before interest and taxes would be unpredictable for the company, even if all the other factors remain the same. Formula for determining Degree of Operating Leverage The formula used for determining the Degree of Operating Leverage or DOL is as follows: DOL = % Change in EBIT / % Change in Sales The Degree of Operating Leverage Ratio helps a company in understanding the effects of operating leverage on the company’s probable earnings. It is also important in determining a suitable level of operating leverage which can be used in order to get the most out of the company’s Earnings before interest and taxes or EBIT. If the operating leverage is high, then a smallest percentage change in sales can increase the net operating income. The net operating income is the amount of income that is left after payments of fixed cost are made, regardless r egardless of how much sales has been made. Since the Degree of Operating Leverage or DOL helps in determining how the change in sales volume would affect t he profits of the company, it is important to ascertain the value of degree of operating leverage in order to minimize the losses to the company. A business would benefit if the can estimate the Degree of Operating Leverage or DOL. The impact of the leverage on the percentage of sales can be quite striking if not taken seriously; therefore it is really important to minimize these risks of the business. If you get a higher degre e of operating leverage or DOL then you should try and balance the operating leverage to balance with the financial leverage in order to provide with profits to the company. A company’s balance Degree of Operating Leverage can provide the financial
DFL The degree of financial leverage (DFL) is the leverage ratio that sums up the effect of an amount of financial leverage on the earning per share of a company. The degree of financial leverage or DFL makes use of fixed cost to provide finance to the firm and also includes the expenses before interest and taxes. If the Degree of Financial Leverage is high, the Earnings Per Share or EPS would be more unpredictable while all other factors would remain the same. The Degree of Financial Leverage (DFL) can be calculated with the following formula: DFL = % Change in EPS / % Change in EBIT Where EPS is the Earnings per Share and EBIT is the Earnings before interest and Taxes. The degree of financial leverage or DFL helps in calculating the comparative change in net income caused by a change in the capital structure of business. This ratio would help in determining the fate of net income of the t he business. This ratio also helps in determining the suitable financial leverage which is to be used to achieve the business goal. The higher the leverage of the company, the more risk it has, and a business should try and balance it as leverage is similar to having a debt. This formula can be even used to compare data of many companies that can help an investor in deciding which company to invest in, based on the result of how much risk is attached with each companies capital structures. It would help an investor to strike a great deal as when the there is an economic decline the losses of t he company can be substantiated with this investment and during the rise in the economic eco nomic conditions the volume of sales would be well compensated. The degree of financial leverage is useful for figuring out the fate of net income in the future, which is based on the changes that take place in the interest rates, taxes, operating expenses and other financial factors. Debts added to a business would provide an interest expense to the company which is a fixed cost, and this is when the company’s business begins to turn to provide profit. It is important to balance the financial leverage according to the operating costs of the
leverage is an important factor contributing to business profits. Even a small percentage of increase in sales can help in having a greater proportion of profits in the company, so it is really important to maintain a balance between both financial leverage and operating leverage to yield maximum benefits. Operating leverage refers to the percentage of fixed costs that a company has. Stated another way, operating leverage is the ratio of fixed costs to variable costs. If a business firm has a lot of fixed costs as compared to variable costs, then the firm is said to have high operating leverage. These firms use a lot of fixed c osts in their business and are capital intensive firms. A good example of capital intensive business firm are the automobile manufacturing companies. They have a huge amount of equipment that is required to manufacture their product automobiles. When the economy slows down and fewer people are buying new cars, the auto companies still have to pay their fixed costs such as overhead on the plants that house the equipment, depreciation on the equipment, and other fixed costs associated with a c apital intensive firm. An economic slowdown will hurt a capital intensive firm much more than a company not quite so capital intensive.
You can compare the operating leverage for a capital intensive firm, which would be high, to the operating leverage for a labor intensive firm, which would be lower. A labor intensive firm is one in which more human capital is required in the production process. Mining is considered labor intensive because much of the money involved in mining goes to paying the workers. Service companies that make up much of o ur economy, such as restaurants or hotels, are labor intensive as well. They all require more labor in the production process than capital costs.
company as it would minimize the level of risks involved.
Financial leverage refers to the amount of debt in the capital structure of the business firm. I f you can envision a balance sheet, financial leverage refers to the right-hand side of the balance sheet. Operating leverage refers to the left-hand side of the balance sheet - the plant and equipment side. Operating leverage determines the mix of fixed assets or plant and equipment used by the business firm. Financial leverage refers to how the firm will pay for it or how the operation will be financed. As discussed earlier in this article, the use of financial leverage, or debt, in financing a firm's operations, can really improve the firm's return on equity and earnings per share. This is because the firm is not diluting the owner's ear nings by using equity financing. Too much financial leverage, however, can lead to the risk of default and bankruptcy.
In difficult economic times, firms that are labor intensive typically have an easier time surviving than capital intensive firms. What does operating leverage really mean? It means that if a firm has high operating leverage, a small change in sales volume results in a large change in EBIT and ROIC, return on invested capital. In other words, firms with high operating leverage are very sensitive to changes in sales and it affects their bottom line quickly. It is fully based on fixed cost. So, the higher the fixed cost of the company the higher will be the Break Even Point (BEP). In this way, the Margin of Safety and Profits of the company will be low which reflects that the business risk is higher. Therefore, low DOL is preferred because it leads to low business risk.
The DFL is based on interest and financial charges, if these costs are higher DFL will also be higher which will ultimately give rise to the financial risk of the company. If Return on Capital Employed > Return on debt, then the use of debt financing will be justified because, in this case, the DFL will be considered favorable for t he company. As the interest remains constant, a little increase in the EBIT of t he company will lead to a higher increase in the earnings of the shareholders which is determined by the financial leverage. Hence, high DFL is suitable.
Operating leverage and financial leverage both magnify the changes that occur to earnings due to fixed costs in a company’s capital structures. Operating leverage magnifies changes in earnings before interest and taxes (EBIT) as a response to changes in sales when a company's operational costs are relatively fixed. Financial leverage magnifies how earnings per share (EPS) change as a response to changes in EBIT where the fixed cost is that of financing, specifically interest costs. Businesses with higher ratios of fixed costs to v ariable costs are characterized as using more operating leverage, while businesses with lower ratios of fixed costs to variable costs use less operating leverage. Utilizing a higher degree of operating leverage increases the r isk of cash flow problems resulting from errors in forecasts of future sales. Earnings per share become more volatile when t he DFL is higher. Financial leverage magnifies earnings per share and returns because interest is a fixed cost. When a c ompany's revenues and profits are on the rise, this leverage works very favorably for the company and for investors. However, when revenues or profits are pressured or falling, the exponential effects of leverage can become problematic. While operating leverage delineates the effect of change in sales on the company’s operating earning, financial leverage reflects the change in EBIT on EPS level. Low operating leverage is preferr ed because higher DOL will cause high BEP and low profits. On the other hand, High DFL is best bec ause a slight rise in EBIT will cause a greater rise in shareholder earnings, only when the ROCE is greater than the after-tax cost of debt.
