1. Financial and Other Leverage
Presentation
Chapter 5
Financial and Other Leverage

2. 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.

3. 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.

4. 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.

5. 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.

6. 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.

7. 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.

8. 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.

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

10. Answer
We get ROI.
EBIT x Sales
Sales Assets

11. Question
What is the weaknesses of profit margin?

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

13. Question
What is the weaknesses of asset turnover?

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

15. 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.

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

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

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

19. 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. .

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