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9 Cards in this Set
- Front
- Back
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Leverage |
An investment strategy of using borrowed capital to increase the potential return of an investment Two sources of leverage are operating and financial leverage |
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Operating leverage |
A financial efficiency ratio used to measure what percentage of total costs are up of fixed costs and variable costs. Calculates how well fixed costs are used to generate profits. Used to calculate break even point and estimate the effectiveness of pricing structure. |
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Degree of Operating Leverage (DOL) |
Used to quantify a company’s operating risk. Shows extent to which operating profits change as sales volume changes. |
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Low DOL |
Company’s variable costs are larger than it’s fixed costs. Significant increase in company’s sales will not lead to substantial increase in operating income. Company does not need to cover large fixed costs. |
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High DOL |
Company’s fixed costs exceed its variable costs. Company can increase operating income by increasing sales. Company must maintain high sales to cover all fixed costs. |
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Financial Leverage |
Use of borrowed money to finance the purchase of assets while expecting income or capital gained from new asset will exceed cost of borrowing. Two sources of financial leverage are Debt and Preferred stock . Successful use of financial leverage increases return on equity. |
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Preferred Stock |
A source of financial leverage due to fixed dividend payments. |
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Using debt financing instead of equity financing |
More volatile net income More risk(financial risk) |
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Financial Leverage |
Measured by the Debt to Equity Ratio: Determines amount of financial leverage of a firm and the proportion of debt to the firm’s equity Shows how likely the borrowing entity will face difficulties in meeting obligations or if it’s level of leverage are at healthy levels. |
