Measures of Leverage

Question 1

Explain leverage

Answer 1

the amount of fixed costs a firm has

Question 2

Explain business risk

Answer 2

refers to the risk associated with a firm’s operating income and is the result of uncertainty about a firm’s revenues and the expenditures necessary to produce those revenues. Business risk is the combination of sales risk and operating risk.

Question 3

Explain sales risk

Answer 3

the uncertainty about the firm’s sales.

Question 4

Explain operating risk

Answer 4

the additional uncertainty about operating earnings caused by fixed operating costs. The greater the proportion of fixed costs to
variable costs, the greater a firm’s operating risk.

Question 5

Explain financial risk

Answer 5

the additional risk that the firm’s common stockholders must bear when a firm uses fixed cost (debt) financing. When a company finances its
operations with debt, it takes on fixed expenses in the form of interest payments. The
greater the proportion of debt in a firm’s capital structure, the greater the firm’s financial risk.

Question 6

Degree of operating leverage (DOL) =

Answer 6

(Revenues - variable operating costs) / (revenues - variable operating costs - fixed operating costs)

Question 7

To calculate a firm’s DOL for a particular level of unit sales, Q, DOL is:

Answer 7

[Q(P-V)] / [Q(P-V)-F]

%change in EBIT / %change in sales

Question 8

Degree of financial leverage (DFL)

Answer 8

The ratio of the percentage

change in net income (or EPS) to the percentage change in EBIT

Question 9

For a particular level of operating earnings, DFL is calculated as:

Answer 9

EBIT / (EBIT-interest)

Question 10

Degree of total leverage (DTL)

Answer 10

DTL measures the sensitivity of EPS to change in sales.

Question 11

DTL is computed as

Answer 11

DOL x DFL

Question 12

Breakeven Quantity

Answer 12

The level of sales that a firm must generate to cover all of its fixed and variable costs

Question 13

Breakeven quantity of sales

Answer 13

the quantity of sales

for which revenues equal total costs, so that net income is zero.

Question 14

Contribution margin

Answer 14

the difference between price and variable cost per unit, is available to help cover fixed costs.

Question 15

Breakeven quantity of sales, Q(BE) =

Answer 15

(fixed operating costs + fixed financing costs) / (price - variable cost per unit)

Question 16

Operating breakeven quantity of sales, Q(OBE) =

Answer 16

Fixed OC / (Price - variable cost per unit)

Question 17

Cost structure

Answer 17

The mix of a company’s VC and FC

Question 18

Elasticity

Answer 18

The %change in one variable for a %change in another variable; a general measure of how sensitive one variable is to a change in another variable.

Question 19

Net profit margin

Answer 19

ROA / Asset turnover

Question 20

Financial leverage

Answer 20

ROE / ROA

Question 21

Inventory turnover

Answer 21

Cost of sales / Average inventory

Question 22

Working capital turnover

Answer 22

Revenue / Average working capital

Question 23

Fixed asset turnover

Answer 23

Revenue / Average net fixed assets

Question 24

Total asset turnover

Answer 24

Revenue / Average total assets

Question 25

Days of sales outstanding (DSO)

Answer 25

Number of days in period / Receivables turnover

Question 26

Working capital

Answer 26

The difference between current assets and current liabilities.

Question 27

Degree of operating leverage definition

Answer 27

The ratio of the percentage change in operating income to the percentage change in units sold; the sensitivity of operating income to changes in units sold.