Principles of Managerial Finance

508 PART 4 Long-Term Financial Decisions

capital structure
The mix of long-term debt and
equity maintained by the firm.

TABLE 12.1 General Income Statement Format and Types

of Leverage

Sales revenue

Less:Costofgoodssold

Operating leverage Gross profits

Less:Operatingexpenses

Earnings before interest and taxes (EBIT)

Less:Interest

Net profits before taxes Total leverage

Less:Taxes

Financial leverage Net profits after taxes

Less:Preferredstockdividends

Earnings available for common stockholders

Earnings per share (EPS)

LG1 LG2

leverage
Results from the use of fixed-cost
assets or funds to magnify
returns to the firm’s owners.

12.1 Leverage

Leverageresults from the use of fixed-cost assets or funds to magnify returns to

the firm’s owners. Generally, increases in leverage result in increased return and

risk, whereas decreases in leverage result in decreased return and risk. The

amount of leverage in the firm’s capital structure—the mix of long-term debt and

equity maintained by the firm—can significantly affect its value by affecting

return and risk. Unlike some causes of risk, management has almost complete

control over the risk introduced through the use of leverage. Because of its effect

on value, the financial manager must understand how to measure and evaluate

leverage, particularly when making capital structure decisions.

The three basic types of leverage can best be defined with reference to the

firm’s income statement, as shown in the general income statement format in

Table 12.1.

• Operating leverageis concerned with the relationship between the firm’s
  sales revenue and its earnings before interest and taxes, or EBIT. (EBIT is a
  descriptive label for operating profits.)


• Financial leverageis concerned with the relationship between the firm’s EBIT
  and its common stock earnings per share (EPS).


• Total leverageis concerned with the relationship between the firm’s sales rev-
  enue and EPS.

We will examine the three types of leverage concepts in detail in sections that

follow. First, though, we will look at breakeven analysis, which lays the founda-

tion for leverage concepts by demonstrating the effects of fixed costs on the firm’s

operations.