This lesson examines leverage as a measure of risk and return in capital structure decisions. It covers operating leverage, financial leverage, and combined leverage, and their impact on earnings before interest and taxes (EBIT) and earnings per share (EPS). Leverage analysis is a core component of the CMA curriculum and university-level corporate finance courses .

 

  • Leverage Defined: Leverage refers to the use of fixed costs to amplify the potential return on investment. While leverage can increase returns when the business is doing well, it also increases the risk of losses when performance declines. The IIS University Management Accounting syllabus identifies “Financial Leverage: Measures – EBIT, EPS Analysis, Operating Leverage, Financial leverage, Business and Operating Risks” as a core topic .

  • Operating Leverage: Operating leverage is the extent to which a firm uses fixed costs in its operations. It is measured by the ratio of fixed costs to total costs.

    • Degree of Operating Leverage (DOL): DOL = Contribution / EBIT

    • High operating leverage means that a small change in sales will result in a large change in operating income (EBIT), but also means higher risk.

  • Financial Leverage: Financial leverage is the extent to which a firm uses fixed-cost sources of finance (debt) to finance its assets. It is measured by the ratio of debt to equity.

    • Degree of Financial Leverage (DFL): DFL = EBIT / (EBIT – Interest)

    • High financial leverage means that a small change in EBIT will result in a large change in earnings per share (EPS), but also increases financial risk.

  • Combined Leverage: Combined leverage (also known as total leverage) is the product of operating and financial leverage. It measures the total risk of the firm.

    • Degree of Combined Leverage (DCL): DCL = DOL × DFL = Contribution / (EBIT – Interest)

    • The University of Peradeniya syllabus identifies “Leverage Analysis (Operating Leverage, Financial Leverage and Combined Leverage)” as a key topic .

  • Impact on Shareholders’ Returns: Leverage affects the return on equity (ROE) and earnings per share (EPS). When a firm earns a return on its assets that is higher than the cost of debt, financial leverage will increase the return to shareholders. The IIS University syllabus explicitly covers “Effects of Leverage on Shareholders’ Returns” .

 

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