This article is more specific about accounting and finance as a business function. In it, you will learn about how companies finance their expenses. Subsequent topics are on break-even analysis, budgeting, working capital management, and capital budgeting, including calculating the cost of capital.
I present it in a separate article for financial reporting, describing the basics of financial statements, balance sheets, income statements, cash flow statements, and financial ratios. Here, I will only discuss financial leverage.
What are accounting and finance?
Accounting and finance are business functions concerned with managing business money, including recording and reporting financial transactions. This department is responsible for efficient financial management and financial control necessary to support all business activities.
Financial information is used by internal users such as management in making decisions related to human resources, operations, and marketing. Likewise, external users such as investors, creditors, banks, analysts rely on financial information published by the company, a financial statement, to make economic decisions regarding the company.
Guide to Business and Management
Accounting and finance department’s tasks and responsibilities
Although the accounting and finance functions are under the same department, they have somewhat different duties.
Accounting does not deal directly with how to raise and allocate money even though it manages company finances. Instead, it only processes and records company transactions, which will later be reported as financial statements. Accountants check and ensure all transactions have been recorded and authorize each division for each recorded financial transaction.
- Accounting also deals with taxes. Accountants manage the company’s financial data for tax calculations.
The finance function deals directly with money. Its main task is to raise, manage, allocate funds and make payments in the company. Another responsibility is managing the company’s cash flow, ensuring sufficient cash is available to meet the company’s needs – both for working capital and capital expenditures.
The following are the accounting and finance department’s tasks and responsibilities:
- Making payments, ensuring stakeholders like suppliers and creditors are paid on time to maintain good relations with them, including taxes.
- Processing incoming payments, including managing invoices and developing credit and collection policies to ensure customers pay invoices on time.
- Making sure everyone gets paid on time.
- Preparing financial reports for external users such as investors, creditors, and other parties plays a role in its business growth.
- Preparing financial information for internal users (management) as input in decision making.
- Avoid errors, fraud, and theft through financial controls, ensuring procedures are properly regulated and comply with standard accounting principles.
- Manage the need and allocation of funds, including raising funds, investing, and using them to support its strategy.
- Creating value, for example, by optimizing the capital structure, obtaining lower loan interest rates, controlling costs, and reducing financial risk.
Sources of finance
A business has several expenditures, which can be:
- Capital expenditure – to purchase fixed assets such as property, machinery, equipment, and factories. It aims to maintain or increase the current production capacity. As capacity increases, companies can generate more output and revenue.
- Revenue expenditure – for payment of daily operations, direct and indirect costs such as wages, raw materials, selling, general and administrative costs.
Businesses finance those expenditures through internal and external sources. Internal sources of financing include:
- Personal funds – for example, from the owner’s savings or donations from family or friends. It is an important resource, especially early in business operations. Sole proprietorships and partnerships usually also rely on it.
- Retained earnings – net income held by the company and not distributed to shareholders as dividends. In the financial statements, you can find it in shareholders’ equity.
- Asset sales – for example selling old assets such as machinery or equipment. It may also come from selling securities held by the company or divesting a subsidiary.
Internal financing sources are inexpensive. For example, a business does not need to pay interest because it uses its own funds to finance activities. However, internal financing capacity is usually more limited. When newly founded, the business has not yet generated revenue and therefore no retained earnings. As a result, companies usually mix it with external financing.
External financing sources are relatively varied, and broadly, they fall into two categories:
Debt – a loan with an obligation to repay principal plus interest. It can be short-term or long-term. Debt may come from bank loans, debt securities such as commercial paper, medium-term notes, or bonds. Companies must pay off debt, regardless of the company’s financial condition.
Equity – money given in compensation for ownership of shares in the company. Equity capital suppliers are called shareholders, stock investors, or owners, which obtain a return from dividends distributed or increased share prices. Equity does not require the company to make regular payments like debt. However, shareholders may have an interest in influencing management decision-making.
- Common stock – shares with voting rights to represent ownership in the company. Common stockholders claim on the business’ assets upon liquidation but receive it after the obligations to creditors, and preferred stockholders are satisfied.
- Preferred stock – shares without voting rights but have a claim on assets and dividends before common stockholders. So, when a company distributes dividends, preferred stockholders get it first, and then, if it remains, it is distributed to common stockholders.
Details of business financial sources
Government grants – government financial assistance to support business activities, usually part of a program to foster entrepreneurship to encourage economic activity.
Subsidies – government financial assistance to reduce production costs, generally for businesses where the output has a large impact on society and the economy, for example, labor-intensive businesses such as agriculture or crafts.
Factoring – the company sells invoices for accounts receivable to a specialist company (called a factoring company or simply factoring) and, in return, receives cash. The factoring company will then collect the receivables from the customer. The risk of bad debts is borne by the company under a with recourse agreement. On the other hand, under a without recourse agreement, the factoring company bears the risk.
Business angels – individuals who invest large sums of money in startup companies with high growth potential and, therefore, returns. They provide funding but are often not involved in the business decision-making process. They bear a high risk because startups have a high risk of failure.
Donations – The most common way to raise donations is through online channels, known as crowdfunding. Funds come from a large number of parties, but each usually contributes a small amount of money.
Venture capital – a venture capital firm manages funds from various parties and invests them into new businesses, usually involved from the early stages of the business. They target businesses with high growth potential. They then sell the business when it is feasible to sell at a profit to another company. Or, they offer to the public through an initial public offering.
Hire purchase – the company purchases an asset, say a machine, and engages a third party, a financial company, which will pay the seller of the machine in full. The company must pay installments to the financial company (including interest) and only own the asset if the installments have been paid off.
Trade credit – the company purchases goods such as raw materials from suppliers and pays for them later, usually within 30-90 days. In addition to discounts from suppliers, later payments – without penalty – to suppliers are a source of cash because the company can use it to pay for other expenses.
Leasing – the company uses assets such as property, machinery, and equipment from the leasing company in exchange for regular payments for a predetermined period. Different from hire purchase, the company will not own assets. But, at the end of the lease, the leasing company usually will offer the company whether to buy the asset or not.
Overdraft – a bank service facility where a company can withdraw money above its available funds in the account. Interest is paid only when the business is overdrawn. The withdrawal amount depends on the need and time. For example, the company has sold some products, but most of them are still not paid in cash by customers. At the same time, the company has to pay its suppliers. In such cases, the company may use the overdraft facility to pay.
Debenture – debt instrument without collateral. Holders are entitled to an agreed fixed return rate but have no voting rights in the company. Because they aren’t backed by collateral, they rely on issuers’ creditworthiness and reputation to be willing to provide loans.
Debt securities – companies raise funds by issuing debt securities to borrow from the public. Companies must pay regular interest and principal as they fall due. It can be short-term debt securities (called bills) such as commercial paper, which have a maturity of one year or less. Or, it can be medium-term debt securities (known as medium-term notes or MTN) and long-term debt securities (known as bonds).
Bank loan – the company applies for a loan to the bank, perhaps for working capital or investment. This alternative is usually more expensive than raising funds through debt securities.
Equity capital – the funds the company gets from selling its shares. Private limited companies cannot sell their shares directly to the general public. Instead, if they want, they must go public by listing their shares on the stock exchange.
- If it is a first-time corporate action, we call it an initial public offering (IPO). If it’s the second or so, we call it a right issue.
Break-even analysis is used to determine the quantity required to cover all production costs. However, before discussing break-even analysis, let’s review a little about revenue and costs.
Revenue streams – where revenue comes from, especially those related to recurring revenue. Take the coffee beverage franchise business, for example. Its main revenue stream comes from selling coffee and from fees from franchisees.
Total revenue is the total sales earned by a business from its various product lines. A large business typically has multiple revenue segments, which is important to diversify revenue streams and avoid the concentration risk on a single product. Meanwhile, a small business may rely solely on revenue from selling one product. We calculate the total revenue by the following formula:
- Total revenue = Selling price x Quantity sold
Average revenue is equivalent to total revenue divided by quantity sold. We also call it revenue per unit. If a business sells a product line for the same price, the average revenue equals the selling price.
- Average revenue = Total revenue / Quantity sold
Marginal revenue is the increase in total revenue from selling one more unit. It is equal to the change in total revenue divided by the change in total quantity sold. Total revenue is maximum when marginal revenue is zero.
- Marginal revenue = ∆Total revenue /∆ Quantity sold
Fixed costs do not go up or down when the output volume changes. When production equals zero, the company still bears it. Examples are machine rent, bank loan costs, non-production employee salaries, and utilities.
Variable costs increase or decrease with the production volume. They rise when the production volume increases and fall when the production volume falls. And, they are equal to zero when the company is not producing. Examples are raw materials, energy, and production labor costs. The total variable cost equals the variable cost per unit (average variable cost) times the quantity.
- Total variable cost = Average variable cost × Quantity
Semi-variable costs contain both variable and fixed costs. An example is a salary, which is fixed for regular hours and variable for overtime hours.
Direct costs can be traced or directly related to the production of goods or services. An example is raw materials.
Indirect costs cannot be clearly linked to the production or sale of the product. Examples are office equipment, office technology, and advertising.
The break-even point is the output level at which total revenue equals total production costs. Thus, there is no loss or profit.
Total contribution refers to the remaining revenue after the business has paid all variable costs. As a result, it is available to cover fixed costs and profits. Also known as contribution margin.
- Total contribution = (Price – Average variable cost) x Quantity
- Total contribution = Total revenue – Total variable cost
- Contribution per unit = Price – Average variable cost
- Contribution margin ratio = (Total revenue – Total variable cost)/ Total revenue
Break-even quantity (BEQ) – the quantity when total costs equal total revenue.
- Total revenue = Total cost
- Total revenue = Total fixed cost + Total variable costs
- Total revenue – Total variable cost = Total fixed cost
- Quantity x (Price – Average variable cost) = Total fixed cost
- Quantity x Contribution per unit = Total fixed cost
- Quantity = Total fixed cost / Contribution per unit
We can also calculate how much quantity to achieve the targeted profit. The trick, you add the target profit to the total fixed cost. Then, divide the result by the contribution per unit.
- Quantity = (Total fixed cost + Target profit) / Contribution per unit
Break-even price – the price at which total costs equal total revenue for a given quantity.
- Price x Quantity = Total cost
- BEP= Total cost / Quantity
- Price = (Total fixed cost + Total variable cost) / Quantity
- Price = Average fixed cost + Average variable cost
To achieve the targeted profit for a given total output, we can calculate the break-even price as follows:
- Break-even price = (Total cost + Target profit) / Quantity
Margin of safety shows how many requests exceed or fail to exceed the break-even quantity. The bigger it is, the better. We calculate it by subtracting the break-even output from the current output level.
- Margin of safety = Actual quantity – Break-even quantity
Budgeting is about making a budget, which is a plan or estimate of the costs incurred or the income earned by the company over a certain period. Broadly speaking, the budget is important because it serves as planning and guidance, coordination, control, and motivation. For example, related to control, the budget ensures the company manages expenses as planned.
- Cost center – a business unit or department without contributing to profits directly but consumes costs. Examples are the human resources department and the accounting department. They must operate efficiently and keep costs below budget.
- Profit center – a business unit or department which not only consumes costs but also generates revenue. They are strategic for the company because they generate profits for the company. Managers in these departments must know how to best use resources to maximize profitability.
Budget variance – appears when the budgeted figures do not equal the actual figures. It may be related to costs as well as revenue.
Budget variance = Actual figure – Budgeted figure
- Favorable variance – when the difference is financially favorable for the company. For example, actual revenue exceeds budgeted/estimated revenue. Or when costs are lower than budgeted.
- Adverse variance – when revenue is less than planned or costs exceed the budget.
Working capital management
Working capital management deals with the money flowing in and out of day-to-day operations. It is related to how companies convert their liquid assets into cash and use them to pay short-term liabilities. It is important to ensure the company has available funds to finance day-to-day expenses. Often associated with liquidity management.
- Liquidity management – about how to manage short-term finances so the company can generate cash when needed.
Working capital is equivalent to current assets minus current liabilities.
- Working capital = Current assets – Current liabilities
Current assets – the economic benefits the company expects to receive in the next 12 months. Companies expect to convert them into cash inflows or other economic benefits (under accrual accounting). Examples are cash, cash equivalents, accounts receivable, and inventories.
Current liabilities – liabilities are maturing within the next 12 months. It could be an outgoing payment or an obligation to provide goods and services in the future. Items include short-term debt, accounts payable, and deferred income.
Working capital/liquidity indicators
The following ratios are used to evaluate liquidity or working capital management:
Inventory turnover = Cost of goods sold / Average inventory
- Inventory turnover measures whether inventory management is effective or not. A higher ratio is preferable because the company can more quickly convert inventory into sales.
Days of inventory on hand (DOH) = 365 / Inventory turnover
- The DOH shows how many days, on average, a company converts its inventory into sales. A lower ratio is preferable because the company generates sales more quickly for any available inventory.
Accounts receivable turnover = Revenue / Average Accounts Receivable
- Accounts receivable turnover describes how well the company manages credit sales. A higher ratio is more desirable because the company can collect cash more quickly, and it accumulates less as accounts receivable.
Days of sales outstanding (DSO) = 365 / Accounts receivable turnover
- DSO shows the time it takes to collect payments from customers. A lower DSO ratio is more desirable because the company takes less time to raise money.
Accounts payable turnover = Purchases / Average accounts payable
Purchases = Ending inventory + Cost of goods sold – Beginning inventory
- Accounts payable turnover shows the number of times in a year the company pays suppliers. Lower accounts payable turnover is preferred because it can use it for other purposes before giving it to suppliers.
Days payable outstanding (DPO) = 365 / Accounts payable turnover
- DPO shows the average time (in days) it takes the company to pay suppliers. A higher ratio is preferred because the company is more flexible in spending money before paying suppliers.
Working capital turnover = Revenue / Average working capital
- The working capital turnover ratio tells how effectively a company manages its working capital to generate revenue, of which a higher ratio is preferred.
Current ratio = Current assets / Current liabilities
- The current ratio measures how sufficient the company’s current assets are to pay current liabilities. A ratio of less than one usually indicates a potential liquidity problem because it does not have sufficient current assets to pay its current liabilities.
Quick ratio = (Cash and cash equivalents + Short term investment + Accounts receivable) / Current liabilities
- The quick ratio excludes less liquid items such as inventories and does not contribute to future cash inflows such as prepaid expenses. A higher quick ratio is preferred, indicating better liquidity.
Cash ratio = Cash and cash equivalents / Current liabilities
- The cash ratio only considers the most liquid or near-cash items. A higher cash ratio is more desirable because it indicates better liquidity.
Working capital cycle
The working capital cycle shows how cash flows from day-to-day operations into and out of the company. It starts from:
- Purchasing inputs such as raw materials from suppliers.
- Deliver it to the warehouse or to the production facility.
- Converting raw materials into output.
- Selling output to customers.
- Collect payment.
- Use sales proceeds to pay suppliers and other current liabilities.
How long the above process takes, that’s the operating cycle, the time it takes to convert raw materials into cash from sales. We calculate it by the formula below:
- Operating cycle = DSO + DOH
The cash conversion cycle refers to the operating cycle after adjusting for the time it takes to pay suppliers. Also known as a net operating cycle.
- Cash conversion cycle = DSO + DOH – DPO
- Cash conversion cycle = Operating cycle – DPO
Problems in working capital management
Overstocking – the company keeps too much inventory. As a result, inventory costs increase. It may be due to its failure to drive sales or forecast errors, resulting in more being produced than sold.
- Understocking – the company keeps too little inventory. As a result, companies cannot optimize sales, especially when market demand is high. That may be due to inadequate production due to management forecast errors.
Falling market demand – let’s say a recession hits the economy. The outlook for consumer income and spending is deteriorating, lowering demand for goods and services.
Excessive borrowing – the company has too much short-term debt. Under normal circumstances, it might not be a problem since the company makes enough money. But, if market demand falls, problems arise. The company still has to pay interest and principal debt even though it does not generate revenue.
Bad credit and collection policies – too-lenient credit terms make customers more likely to pay late, reducing cash inflows. But, if it’s too tight, customers can also turn to competitors with more lenient offerings. Another problem is the increase in bad debts.
Investment is spending on long-term assets, expecting to earn more money in the future. For example, it might build factories, buy machines and vehicles, or acquire other companies. The money spent on investment is called capital expenditure.
Investment appraisal is about evaluating an investment project objectively to determine whether it is profitable or not. It is based on whether the investment generates more money in than money out?
- Cash outflow – money the business spends on the investment, such as building a new factory.
- Cash inflows – money received from investment projects, for example, from selling the new factory’s output.
- Net cash flow = Total cash in – Total cash out.
Incremental cash flow points to the extra cash flow realized when a decision is executed, for example, the decision to invest in a project. So, it is the difference between the company’s cash flow with and without the project. If the project generates positive cash flow, the company’s cash flow increases, and the investment decision is preferred.
Conventional cash flow refers to a series of cash flows, where an initial outflow is followed by a series of inflows.
- Unconventional cash flow – an initial outflow followed by a series of cash inflows and outflows. Thus, there is more than one sign of a change in cash flow.
Capital budgeting is about making capital allocations for long-term investments. It involves assessing and making decisions about large projects, usually with a lifespan of more than one year. Then, the company determines the project’s feasibility and allocates resources accordingly, including how it will finance it.
A capital project is a detailed proposal on a company’s long-term investment. It could be an expansion project to increase its productive capacity, for example, building a new factory. Or, it could be a replacement project, a new product development, or a project to comply with regulations, safety, and environment as required by the government. Also known as investment projects.
- Independent projects – projects in which their cash flows are unrelated.
- Mutually exclusive projects – projects in which their cash flows compete with each other. Say, if project Y and project Z are mutually exclusive, then the firm can only accept one of them, not both.
- Project sequencing – investing in one project creates opportunities for another. In other words, whether or not to invest in the next project depends on the outcome of the existing project.
Capital rationing is limiting the amount of investment for each new project. It assumes the company has a fixed amount of funds to invest, requiring it to allocate to the most profitable projects. In soft rationing, the company can change the investment limit in the future.
- Sunk costs have been incurred by the company and cannot be recovered. In valuing a project, we should ignore it when deciding whether to accept or reject the project because it was incurred in the past.
- Opportunity cost is the cost of the next best alternative we sacrifice when choosing something. Say a company buys a machine. Renting a machine is an opportunity cost if it is the next best alternative.
Methods for evaluating investment projects
Average rate of return (ARR)
Average rate of return is the ratio of the project’s average net profit to its average book value or initial investment cost.
- AAR = Average net income / Average book value
Net present value (NPV)
Net present value (NPV) is the present value of future after-tax cash flows minus the initial investment. Investment into a project is feasible if the NPV is positive. Contrarily, a negative NPV indicates the project is not feasible.
- The NPV profile illustrates the NPV of a project at different discount rates. It is downward sloping because as the cost of capital increases, the NPV falls.
Internal rate of return
The internal rate of return (IRR) points to a discount rate at which the NPV is zero. In other words, the IRR makes the initial investment equal to the present value of the cash inflows.
- IRR is usually used by considering the required rate of return. The project is feasible if it is higher than the required rate of return; otherwise, it is not feasible.
The payback period is the time it takes to recover the initial capital. The calculation is based on the estimated cash flow from the investment. Therefore, the most viable investments are those with the shortest payback period.
- The discounted payback period is the number of years it takes for the present value of all net cash from a project to equal the initial investment. To calculate present value, you discount the cash flows at the discount rate.
The profitability index evaluates the project by comparing the project’s profit with the initial investment. You calculate it by dividing the present value of the project’s expected future cash flows by the initial investment.
- Profitability index = 1 + (NPV / Initial investment)
If it is equal to 1, the project breaks even. If there is more than one, the project makes a profit. And if less than one, the project is a loss because the initial investment is greater than the cash flow generated from the project.
In the company’s perspective, the cost of capital represents the cost of raising debt or equity funds. Whereas, for suppliers of funds, it is the minimum return they require to be willing to provide funds to the company.
Company capital is divided into two categories: equity and debt. In simple calculations, the cost of capital equals the cost of debt plus the cost of equity, weighted by the respective contributions. A popular method for calculating it is the weighted average cost of capital (WACC).
- Weighted average cost of capital (WACC) – the rate of return investors expect to finance a company’s average risk investment. In simple terms, we add up the costs of equity and debt, weighted according to their respective contributions to the firm’s capital structure.
- Target capital structure – how much debt and equity the company chooses to achieve or maintain to maximize the firm value.
- Current capital structure – how much debt and equity is in the company’s current finances, which can be long-term debt, short-term debt, common stock, and preferred stock.
Cost of debt
The cost of debt is the cost borne by the company to collect debt capital.
- Unlike equity capital, creditors earn interest and principal repayments. In addition, for debt securities, they also have the potential to get capital gains when trading them instead of holding them to maturity.
When we calculate the cost of capital, the cost of debt is adjusted to the tax rate because interest expense is tax-deductible. The two approaches to calculating the cost of debt are:
- Yield‐to‐maturity approach – the rate of return on bonds assuming investors buy them at the current market price and hold them to maturity.
- Debt-rating approach – based on bond yields with ratings and maturities comparable to the company’s current debt. We use this approach if the company does not issue bonds, so yield to maturity data is unavailable.
Cost of preferred stock
The cost of preferred stock is the cost incurred by the company to issue preferred stock.
- Cost of preferred stock = Preferred stock dividend per share / Current price of preferred stock
The formula above assumes the company pays dividends at a fixed rate to preferred stockholders. Another assumption is, preferred stock does not have a maturity date and does not have callable and convertible features.
Cost of equity
The cost of equity implies the return rate required by investors to be willing to buy shares of the company. Some approaches to calculating the cost of equity are:
- Capital Asset Pricing Model (CAPM)
- Dividend discount model
- Bond yield plus risk premium
Capital asset pricing model (CAPM) – the required return investors are willing to buy company shares rather than risk-free assets. We calculate the CAPM with the following formula:
CAPM = Risk-free rate + Beta * Risk premium
- Risk-free rate – the rate of return on a risk-free asset. That’s the exact rate of return we get. Time deposit interest is an example. We’ll have it unless the bank goes bankrupt. Because government bond yields are higher than deposit rates and are equally safe, analysts usually use government bond yields rather than deposit rates.
- Beta coefficient, or in short, beta – the systematic risk of a stock or portfolio compared to the market as a whole. A stock with a beta exceeding 1.0 is riskier than average. Whereas, if the beta is below 1.0, it is considered safer than average and will likely fluctuate less than the market average.
- Risk premium – the premium required by investors to invest in the stock market, equal to the expected return on the stock market minus the risk-free rate, usually the yield on a 10-year bond. Also known as equity risk premium or market risk premium.
- Expected return on the market – the percent of return investors expect to receive when investing in the stock market.
- Beta is exposed to systematic risk or non-diversifiable risk, including business risk and financial risk. Sometimes, we must use unlevered beta (eliminating the leverage effect) to reflect comparable business risk (asset beta) when valuing a non-listed project or company.
- The CAPM calculation must include the country’s risk premium by adding the country equity premium to the market risk premium for foreign investors.
Dividend discount model refers to a stock valuation method using dividends paid by companies to shareholders. A stock’s intrinsic value is equal to the present value of the expected future dividends of the stock.
- Gordon growth model – dividend discount model assuming dividends grow at a constant rate. In this model, the current market price of the stock (P0) is equal to the next year’s dividend value (D1) divided by the difference between the constant cost of equity (r) and the expected constant dividend growth rate (g).
P0 = D1/(r-g)
- We get the following cost of equity by rearranging the above formula:
r = (D1 / P0) + g
Bond-yield-plus-risk-premium equals the bond’s yield-to-maturity plus a risk premium.
- Cost of equity = Yield-to-maturity + Risk premium
The risk premium represents the additional return required by stock investors. Stocks are riskier than bonds. Therefore, when they buy stocks instead of bonds, they assume a higher risk. It is estimated using the historical spread between bond yields and stock yields.
Guide to Understanding and Analyzing Financial Statements
Leverage is when the company bears the fixed costs of operating the business. Fixed costs continue to exist and remain unchanged or do not vary with the firm’s output level. When output rises or falls, firms bear the same total fixed costs. They are broadly divided into two categories:
- Operating expenses such as machine costs, rent, and depreciation.
- Financial costs such as interest expense.
Leverage poses risks to the company, resulting in uncertainty about earnings and cash flows. The risks associated with leverage fall into two categories:
- Business risk – uncertainty in the company’s profits and cash flows due to uncertainty in revenue (sales risk) and due to the company’s cost structure (operating risk).
- Financial risk – uncertainty in earnings and cash flows due to financial leverage such as debt and rent, which results in regular payments.
Total leverage is equal to the sum of financial leverage and operating leverage. The degree of total leverage (DTL) shows how sensitive the company’s net profit is to units sold. It is affected by operating fixed costs and financial fixed costs. We calculate DTL with the following formula:
- DTL = Percentage change in net profit / Percentage change in units sold
- DTL = DOL x DFL
Financial leverage refers to how much a company depends on debt to acquire additional assets relative to equity capital.
The degree of financial leverage (DFL) is equal to the percentage change in net profit divided by the percentage change in operating profit. It measures the sensitivity of the cash flows available to owners when operating profit changes. High leverage makes profits tend to be unstable.
- DFL = Percentage change in net profit / Percentage change in operating profit
Operating leverage shows the extent to which fixed costs are used in operations. Thus, higher fixed costs, relative to variable costs, indicate higher operating leverage.
- High operating leverage makes the company’s profit sensitive to changes in sales volume. It also increases the break-even point. Companies must sell products at high volumes to cover operating costs and generate profits. A slight decrease in sales volume can significantly reduce profits.
The degree of operating leverage (DOL) is equal to the percentage change in operating profit divided by the percentage change in units sold. Thus, it tells you the sensitivity of operating profit to changes in sales volume.
- DOL = Percentage change in operating profit / Percentage change in units sold
Higher DOL when most of the operating costs are fixed costs. It is considered riskier because changes in sales volume have a significant effect on operating profit.