Solvency Ratios: Operating and Financial Leverage
No.
Extra debt doesn't help to reduce losses.
__Solvency__ refers to a company's ability to meet its long-term financial obligations. A company should own more than it owes its creditors. A solvent company manages its debt well and has a positive net worth.
Solvency ratios compare the company's profitability to its obligations. There are two types of solvency ratios: debt ratios and coverage ratios. Debt ratios use information from the balance sheet to show how the company's debt capital compares to its equity capital. Coverage ratios use information from the income statement to see how well the company can cover its debt payments.
__Operating leverage__ is different from financial leverage. It measures the use of fixed costs. A greater use of fixed costs over variable will return a greater percentage of additional revenues to investors.
Valley Technologies and Ice Chip are two semiconductor makers. Valley uses old technology and relies on a large number of employees to make its products by hand. Ice Chip has invested in sophisticated equipment and can make large batches of product with relatively few employees. The equipment that Ice Chip uses is a fixed cost. The payments for it will not change when volumes of product change. Valley's employees, on the other hand, are a variable cost. As additional orders come in, Valley hires more employees to fill them.
Which company, do you think, has more operating leverage?
Exactly.
If a company earns a positive return for its owners, more debt leaves additional income available to owners, leveraging those results. But it works the other way, too. If there are losses, the losses are also amplified by financial leverage.
There's both opportunity and danger in debt.
To summarize:
[[summary]]
No, it's Ice Chip.
Absolutely!
Selected data from these companies is shown below.
| In Thousands | Valley | Ice Chip |
|---------------|--------|----------|
| Equipment (fixed) | 20K | 100K |
| Labor cost (variable) | 100K | 20K |
| Total cost | 120K | 120K |
What is the operating leverage for Valley?
Correct.
Calculations for Valley's operating leverage are:
$$\displaystyle \frac{20}{120} \approx 0.17 $$
For Ice Chip, the operating leverage is:
$$\displaystyle \frac{100}{120} \approx 0.83 $$
No.
Make sure you are using total cost in your calculation.
No.
Be sure that fixed cost is in the numerator.
It uses more fixed costs, and therefore has more operating leverage.
The operating leverage for these companies is calculated as fixed costs divided by total costs.
If either firm wants to finance new assets, they can either borrow the money through debt or raise the money from investors. Companies that prefer to use debt will have a higher level of __financial leverage__. The __financial leverage ratio__ is average total assets divided by average total equity. A higher ratio means more financial leverage is being used.
If business is booming, do you think a company would want a higher or lower financial leverage ratio?
You got it!
No, actually higher would be better.
To see why, assume the same amount of income (EBIT) either way. A smaller amount of equity means greater returns per dollar of equity. That will continue even at greater levels of sales because interest payments are fixed and will not rise with greater sales volumes. That is the beauty of financial leverage.
Is there a downside to leverage, though? Yes.
If a company earns an EBIT of zero, then it still has to pay interest after that; more debt means a larger loss. If positive profits are magnified by financial leverage, what do you think happens to negative profits when there is financial leverage?
No.
Consider being in debt, owing interest payments, _and_ losing money on your business all at the same time.
Valley
Ice Chip
0.17
0.50
5.00
Lower
Higher
Nothing
Losses are reduced
Losses are amplified
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