Definitions in Leverage | CFA Level I Corporate Issuers

Welcome back! Today, we’ll explore measures of leverage. We’ll start with an introduction and learn some key terms related to leverage. Let’s dive in!

Understanding Leverage

In this course, we define leverage as the amount of fixed costs a firm has. The higher the fixed costs, the higher the degree of leverage. In some places, leverage is also referred to as gearing.

Fixed costs are expenses that remain the same regardless of the production and sales of the company. These fixed costs may be fixed operating expenses, such as rents and leases, depreciation, and wages for salaried employees, or fixed financing costs, such as interest payments on debt.

Apart from fixed costs, the cost structure of a firm also consists of variable costs, which fluctuate with the level of production and sales. Examples include the cost of raw materials, shipping charges, wages for hourly employees, and sales commissions.

Comparing Two Sports Shoes Manufacturers: Noke and Adodos

Let’s study two sports shoes manufacturers, Noke and Adodos.

• Noke sells each pair of shoes at $10 to retail outlets, and the variable cost of producing each pair is $2. The company has a fixed operating cost of $5,000 and a fixed financing expense of $1,000 each month.
• Adodos also sells each pair of shoes at $10 to retail outlets, but the variable cost of producing each pair is $6. The company has a fixed operating cost of $1,500 and a fixed financing expense of $500 each month.

Since Noke has a higher proportion of fixed costs, its leverage is higher. Let’s see how this translates to its earnings and risk.

How Leverage Affects Earnings and Risk

Imagine that last month, both companies produced and sold 1,000 pairs of shoes. Both companies will have earnings before tax of $2,000. Are they similar in risk and profitability? Let’s dig deeper.

Scenario 1: There is a 50% increase in demand for sports shoes, so both companies increase sales to 1,500 pairs each. Noke will book $6,000 in earnings, while Adodos will book just $4,000 in earnings.

Scenario 2: A deep recession hits, and sales are halved to just 500 pairs. Noke will actually make a loss of $2,000, while Adodos will scrape by with zero earnings.

When we plot the earnings of each company against the number of units produced and sold, it becomes clear how leverage affects a company’s profitability and risk. Although Noke, with its more leveraged cost structure, is more profitable when it sells more, it is also more risky, as any shortfall in sales can quickly translate into losses.

And that’s our quick introduction to leverage and some of its associated terms! In our next lesson, we’ll learn about business risk. See you soon!