YT YouTube2Text

YouTube2Text → Transcripts → CFA Level 1 Free Lesson: Financial Leverage, Operating Leverage, Total Leverage & Breakeven Sales

CFA Level 1 Free Lesson: Financial Leverage, Operating Leverage, Total Leverage & Breakeven Sales — Transcript

by Chalk & Board · 7,300 words · 1,055 segments · language en · Watch on YouTube

Open in transcriber Summarize with AI Download SRT/VTT

Full transcript

0:00so with no further Ado I want to
0:02actually review with you is measures of
0:05Leverage okay now I'm
0:08on in the curriculum to define and
0:11explain leverage business risk sales
0:14risk operating risk and Financial Risk
0:16and classify a risk now this reading on
0:20the measures of Leverage there are
0:22things that you need to focus on and
0:23these are the primary F things you
0:25should focus on number one you should
0:26know the difference between financial
0:28leverage and operating Leverage it's
0:30number one number two you need to know
0:32how to calculate and what are the
0:33components of the degree of operating
0:35leverage the degree of financial
0:37leverage and the degree of total
0:39average and then after that you should
0:41definitely know how to calculate the
0:43break even quantity of sales that covers
0:46all fixed costs and the break even
0:48quantity of sales it just covers
0:50operating fixed costs not financing
0:52fixed costs so those are really the
0:55prime elements that they like to test in
0:57this particular reading so we're going
0:58to go over this reading and make sure
0:59sure that you'd know it and I'm also
1:01going to do a problem with you but I do
1:03want to emphasize that this was a
1:04reading that was started out as a level
1:07two reading in the corporate finance
1:09area of level two then it was put into
1:11both readings level one and level two
1:13and now a couple years ago they removed
1:15it from level two and it's only in level
1:17one so they do like to ask questions
1:19about this and this area of measures of
1:20Leverage is not going to be a reading
1:22again at level two and it's not going to
1:23be level three because there is no
1:25Corporate Finance at level three so with
1:29no further or two Ado let's actually
1:31understand when we talk about leverage
1:33as I just said a moment ago there's two
1:35forms of Leverage there is financial
1:38leverage and there is operating leverage
1:41we're going to primarily focus on
1:43operating leverage but let's distinguish
1:45between operating leverage and financial
1:47leverage financial leverage basically re
1:50refers to the financial risk of the
1:52company and that's based on the amount
1:54of debt that is in the firm's capital
1:57structure as opposed to the equity
1:59because remember you can Finance assets
2:00with debt and or Equity so when we talk
2:02about financial leverage we're generally
2:04talking about the Deb debt the debt
2:06component of a firm's capital structure
2:08and if you remember from the dupon
2:10formula back in the equity and in the
2:13financial reporting and Analysis how do
2:15we calculate financial leverage many
2:17times financial leverage which is a
2:19measure of a firm's Financial Risk is
2:21calculated as assets over Equity assets
2:24over Equity that's how the CFA program
2:27likes to refer to financial leverage as
2:29assets over
2:31Equity now the operating leverage of the
2:34firm is very different we talked about
2:36operating leverage briefly in other
2:37sections but I said we're going to see
2:39it again more in corporate finance
2:41operating Leverage is what portion of a
2:45firm's total costs are fixed as opposed
2:49to operating in nature or fixed as
2:52opposed to variable in nature so if I
2:54take a fir look at a firm's total cost
2:56what portion of those total costs are
2:58fixed as a opposed to variable in nature
3:02okay now fixed costs are going to be any
3:04kind of costs that no matter how many
3:06units we produce we got to cover those
3:08costs if we produce no units we're going
3:10to incur those costs and if we produce a
3:12million units we're going to incur those
3:14costs what are examples of fixed costs
3:18fixed costs would be things like
3:20Insurance rent depreciation those are
3:24all especially if you're using straight
3:25line those are all examples of fixed
3:27costs and what are variable costs
3:29variable costs are costs that can be
3:31controlled especially in the short run
3:33we can control them and they tend to be
3:35what they tend to fluctuate with
3:37production so uh variable costs can be
3:40things like employee salaries it could
3:43also be like raw materials you know
3:45those kinds of things those would all be
3:47examples of variable cost they will all
3:49change with the amount of production so
3:51keep in mind the difference between the
3:53two and always remember that also the
3:55British when they talk about leverage
3:57they also call they refer to it as
3:59gearing ing Okay g e a r i n g so
4:03sometimes on the exam I've actually seen
4:04them use the word gearing okay you might
4:06even see that with me later on in the
4:08real estate material they call it
4:10gearing so remember gearing means
4:12leverage all right and then we also say
4:15that basically that the greater the
4:17proportion of fixed costs to variable
4:19costs the greater the firm's operating
4:21leverage and therefore the greater the
4:22firms operating risk whereas the greater
4:25the proportion of debt in a firm's
4:28capital structure the greater the firm's
4:30Financial Risk okay now I'm
4:33on in the curriculum readings which is
4:36to calculate and interpret the degree of
4:38operating leverage the degree of
4:40financial leverage and the degree of
4:42total leverage now if you actually take
4:45a look at your screen what I've done
4:47here is I've provided you with all the
4:49calculations right up front in terms of
4:51how to come up with the degree of
4:52operating leverage the degree of
4:54financial leverage and therefore the
4:56degree of total leverage if you're
4:58looking at your screen first of all what
5:00I've done in the center of the screen is
5:01I have created a sort of like skeletal
5:04income statement that shows you revenues
5:07minus operating expenses gives you ebit
5:10then from ebit we deduct interest and
5:12taxes and we come up with net income
5:14there's a lot of things that I did not
5:16it's just to keep a skeletal income
5:17statement in our mind when we calculate
5:19the degree of operating leverage the
5:21degree of financial leverage and the
5:22degree of total leverage so to start out
5:25with the degree of operating leverage we
5:28Define the degree of operating leverage
5:31as the percentage change in the
5:34operating income that results from a
5:37percentage change in sales okay that is
5:40the formula percentage change in ebit
5:42divided by the percentage change in
5:43sales now you could try to memorize that
5:46what I always tell people is think look
5:48at the income statement here as looking
5:50from the bottom up from the bottom up
5:52not top down but bottom up so if you
5:54look at it from bottom up think about
5:56the word operating op I'm trying to
5:59calculate the degree of operating
6:01leverage so what am I looking at here
6:03the keyword is operating is net income
6:05if I'm looking bottom up is net income
6:07operating no net income is the net
6:09number what is
6:11Ebid eBid is operating it's the
6:14operating income and that's how it's
6:16referred to many times in the reading is
6:18operating income so what I'm looking at
6:20is I'm going to look at eBid and then
6:22I'm going to be moving up to sales so
6:24the percentage change in ebit divided by
6:26the percentage change in sales that
6:28would isolate what what's the difference
6:29between sales and Ean all of my
6:31operating expenses and what am I trying
6:32to calculate here the degree of
6:34operating leverage so that's how I
6:37always remembered this kind of formula
6:39so I'm looking up the income statement
6:40so it's going to be the percentage
6:41change in ebit divided by the percentage
6:42change in sales another way that you can
6:46calculate and you'll see that I have a
6:47star next to it is we can calculate the
6:50degree of operating leverage as taking
6:52sales and subtracting all of our total
6:55variable costs and then dividing that by
6:57the sales minus the total VAR variable
6:59cost minus the fixed cost so the
7:02difference between the numerator and the
7:04denominator is what fixed cost and isn't
7:06that what operating Leverage is doing
7:08it's telling you what portion of your
7:10total costs are fixed as opposed to
7:12variable in nature so it's really
7:14isolating the fixed cost
7:17component and then if I want to take
7:19that formula I still this is one more
7:21way of expressing the degree of
7:23operating leverage I could break the
7:25sales and the total variable cost down
7:27into quantity times price minus variable
7:30cost per unit so that'll be in the
7:32numerator quantity the amount times the
7:35difference between the price per unit
7:37minus the variable cost per unit because
7:39why if I multiply that through what is Q
7:40* p q * p is sales and what's Q * V
7:44total variable cost and then I divide
7:47that by Q * P minus V minus the fixed
7:50costs okay so keep in mind that P minus
7:52V are per unit times the quantity minus
7:55the fixed cost okay now if you see these
7:58three form formulas these three formula
8:01for the degree of operating leverage the
8:02question becomes Nathan which one do I
8:04need to know do I need to know all of
8:05them one of them primarily I would know
8:07the one that I just starred which is the
8:09second formula sales minus total
8:11variable cost divided by sales minus
8:13total variable cost minus fixed cost
8:15gives me the my degree of operating
8:16leverage why because the F first Formula
8:19the percentage changes in ebit over the
8:20percentage change in sales that's
8:22something where you'd if they wanted you
8:24to calculate it they'd have to show you
8:26what two for two financial statements
8:28from two different years and you'd have
8:30to do a lot of math to come up with that
8:31so that's going to be the less likely
8:33formula that you're going to have to
8:34actually produce on the exam but still
8:36one that you should have in your
8:38notes okay so that is how we calculate
8:42the degree of operating leverage now
8:44also what I want to point out to you is
8:46if you take a look at that formula that
8:48I have starred sales minus total
8:50variable costs over sales minus total
8:52variable cost minus fixed cost what
8:54happens if fixed costs are equal to zero
8:56there are no fixed costs then sales
8:58minus total variable cost in the
9:00numerator over sales minus total
9:01variable cost in the denominator would
9:03be one so our degree of operating
9:04leverage would be one so you would have
9:06a degree of operating leverage equal to
9:08one if there are no fixed costs for the
9:11firm in other words they don't have any
9:12kind of insurance rent depreciation or
9:15the
9:16like okay so that's just something to
9:18point out to you now it's also important
9:21to note that the degree of operating
9:24Leverage is going to be highest at the
9:27lowest level of sales or a low level of
9:29sales and then the degree of operating
9:31leverage will decline as we have higher
9:34levels of sales why because operating
9:37Leverage is about fixed costs that have
9:39to be covered so as we have very little
9:42s at very low levels of sales we're
9:45going to have more or our fixed costs
9:47are going to be a bigger component that
9:48we have to cover so the degree of
9:49operating leverage will be higher but
9:51then as we have more and more sales
9:53those sales are going to cover our fixed
9:54cost and the degree of operating
9:55leverage will decline so just think
9:57about it intuitively
10:00okay continuing along that same slide we
10:03can now move on to the degree of
10:05financial leverage the degree of
10:07financial leverage is interpreted as as
10:09you can see from the formula the ratio
10:12of the percentage change in earnings per
10:14share or net income net they're treating
10:16net income and earnings per share as
10:19synonymous to the percentage change in
10:21eBid so now what are we really doing how
10:23can we think about this the degree of
10:24financial leverage what is an example of
10:27financial leverage what component on the
10:29income statement would reflect amounts
10:31of debt and financial leverage interest
10:35so interest is below ebit right so we're
10:37looking at the difference between ebit
10:39and net income and that's primarily
10:41going to be the interest expense yes
10:43taxes are in there as well but the
10:44biggest component would probably be the
10:46interest expense so again looking at
10:47this from
10:48a looking at this again from a bottomup
10:51perspective we would be looking at it
10:53from net income going up to ebit so be
10:55the percentage change in net income or
10:57percentage change in EPS the divided by
10:59the percentage change in ebit okay so
11:01just constantly look at it as going up
11:03the income statement and again the
11:05difference between ebit and net income
11:06will be primarily the interest expense
11:08which implies financial leverage the
11:11other formula that we can use in order
11:13to calculate the degree of financial
11:15leverage is ebit over ebit minus
11:18interest expense notice what's the
11:20difference between the numerator and the
11:22denominator interest expense interest
11:24expense again reflects what debt
11:26financial leverage so keep that in mind
11:28that is an element of financial leverage
11:30so therefore we can see that this is
11:32really the degree of financial leverage
11:34and again this this measure this degree
11:37of financial leverage is measuring the
11:39sensitivity of earnings per share to
11:42changes uh to the percentage change in
11:45ebit okay so keep that in mind okay so
11:48keep that in mind to the percentage
11:49change in ebit now if I if you look at
11:51that formula if I put in zero for
11:55interest expense what's going to happen
11:57if I put zero into interest expense for
11:58the the degree of financial leverage
12:00it'll be ebit over ebit ebit over ebit
12:02would be one so if interest expense is
12:05equal to zero because the firm doesn't
12:06have any interest expense then the
12:08degree of financial leverage would be
12:09equal to one now again which formula
12:12would I know out of those two definitely
12:15I would know the one that's starred
12:16which is ebit over ebit minus interest
12:18expense to reflect the degree of
12:20financial leverage keep that in
12:23mind now that we understand what is
12:25degree of operating leverage operating
12:27is going to De deal with the operating
12:29expenses it's going to be the percentage
12:30change in ebba divided by the percentage
12:32change in sales and we know that the
12:34degree of financial leverage financial
12:35leverage is implemented through what
12:37interest expense on the income statement
12:39so it's going to be the percentage
12:40change in earnings per share divided by
12:41the percentage change in ebit okay we
12:44now have the degree of operating
12:45leverage and the degree of financial
12:46leverage how do we come up with the
12:48degree of total leverage the degree of
12:51total leverage combines the degree of
12:53operating leverage and the degree of to
12:57financial leverage so one way that we
12:59could come up with the degree of total
13:00average is simply multiplying D time dfl
13:04if you look at the bottom of that same
13:05screen I am now showing you the
13:07different ways to calculate that same
13:09screen I'm showing you the different
13:11ways to calculate degree of total
13:13leverage so one easy way which is the
13:14one that they love to test on the exam
13:16is degree of operating leverage times
13:18the degree of financial leverage equals
13:20the degree of total leverage okay that's
13:22one way now if we look at degree of
13:24total average since degree of total
13:26average en encompasses both the degree
13:28of operating leverage and the degree of
13:30financial leverage we're looking at the
13:31entire income statement bottom up so
13:34would be the percentage change in
13:35earnings per share divided by the
13:37percentage change in sales so that would
13:39basically be measuring again the
13:41sensitivity of earnings per share to
13:45sales to to the change in sales that
13:47would be your degree of total leverage
13:50okay now the other way that we can
13:52calculate the degree of total Leverage
13:55is we could say all right in the
13:56numerator we're going to have sales
13:58minus total variable costs okay and then
14:02in the denominator we're going to have
14:03sales minus total variable cost minus
14:06the fixed cost and then also minus the
14:10interest expense and if we want to
14:12reward that formula using the notation
14:15we could say well again sales minus
14:18total variable cost would be quantity
14:19times price per unit minus variable cost
14:22per unit and then we would divide that
14:24by quantity time price per unit minus
14:26variable cost per unit minus the fix F
14:29cost minus the interest expense and
14:31again what is the difference between the
14:32numerator and denominator the interest
14:34expense which is financial leverage and
14:36the fixed cost which is the operating
14:38leverage so you could see that this is a
14:40Formula it's taking into account both
14:41forms of Leverage in the formula so
14:44therefore there are basically four
14:46different ways of calculating the degree
14:47of total leverage the first one I would
14:49know is multiplying degree of operating
14:51leverage times degree of financial
14:53leverage and then the other one that I
14:54would know the second one would be sales
14:56minus total variable cost over sales
14:58minus Min us total variable cost minus
14:59fixed cost minus interest
15:03expense okay we're going to do a problem
15:05in a moment that's going to test you on
15:06these on these formula but what I want
15:08to do is I want to sort of continue uh
15:10with this reading continue with this
15:12reading finish it up and then we'll do a
15:13problem that encompasses most of the
15:15material in this reading now I'm
15:19on in the curriculum readings just to
15:22analyze the eff of financial leverage on
15:24a company's net income and return on
15:27Equity okay now financial leverage again
15:29we're looking at it as what assets over
15:32Equity that's a measure of financial
15:33leverage and you should already know the
15:36financial leverage assets over Equity
15:38from the dupon formula increasing the
15:40financial leverage of the firm all else
15:43constant does what to the
15:45Roe well it's going to raise Roe okay
15:48it's going to raise Roe because it's
15:50remember from the dupon net income over
15:52sales times sales over assets times
15:54assets over Equity assets over Equity is
15:56financial leverage since I'm multiplying
15:58those three three components if you're
15:59not sure what I'm talking about go back
16:00to the modified traditional dupon that I
16:02did back in the equity section or the
16:05financial uh statement analysis
16:06financial reporting and Analysis section
16:08so assets over Equity is financial
16:10leverage so if we increase the debt
16:12level of the firm we increase the return
16:14to shareholders but we make that return
16:16ever more risky so the impact on the
16:19return on Equity you should already know
16:20is to increase it and then what is going
16:22to be the impact of financial leverage
16:23on net income well financial leverage as
16:26we take on more and more debt in the
16:27firm's capit Capal structure that debt
16:29has to be serviced right there's
16:31interest expense that's going to have to
16:32be paid so that interest expense is
16:34going to be doing what to net income
16:35reducing net income so
16:38higher financial leverage will reduce
16:41net income through the interest expense
16:43but will actually raise the return on
16:45Equity making it ever more risky to the
16:47common shareholders why because even
16:50though net income is going down in the
16:51numerator as we just described Equity is
16:54also going to be going down and what's
16:56going to happen is the the percentage
16:58per the percentage U impact will be more
17:03so that the overall return on Equity
17:05will go up okay because the the the
17:07denominator Equity will go down even
17:09more than the uh than the net income so
17:12therefore overall uh return on Equity
17:15will rise now in the actual readings and
17:17in your other in your prep providers
17:19materials they actually take you through
17:20numerical examples to prove this to you
17:23I don't really think that that is really
17:24necessary I think if you see the numbers
17:26one time it makes sense because the
17:28learning outcome statement is not really
17:29asking you to do these calculations so
17:32just take a look at it because you're
17:33expected to understand the impact but
17:35what I would notice is when you
17:37basically do something where okay you
17:39say here's my revenues here's my
17:41operating expenses here's my eBid okay
17:43and we start out with the ebit and we
17:45say okay here's the ebit assuming all
17:47Equity financing and there's we're going
17:50to assume that there's no debt the
17:51company's completely Equity Finance
17:53there's no debt in the capital structure
17:54so there's no interest expense so what's
17:56going to happen is when we look at that
17:58scenario as they do in the readings and
18:00in the prep providers materials and we
18:01compare that scenario with a scenario
18:03where the firm is half financed with uh
18:07debt and half Finance with Equity
18:09obviously the return on Equity will be
18:11different depending on increases in ebit
18:15so we take a look they they actually
18:17show three scenarios uh where where they
18:19actually prove to you that return on
18:21Equity is going to be higher using
18:24leverage compared to without using
18:26leverage but you should already know
18:27that from the
18:28dupond furthermore you can also take a
18:31look in the calculations in the CFA
18:33books or even in the prep providers
18:34materials and you could see that the use
18:36of financial leverage not only increases
18:39the level of the Roe doesn't only
18:42increase the Roe it also increases the
18:45rate of change of Roe compared to a the
18:48rate of change of Roe when a firm is not
18:51financed with debt okay so it increases
18:53that's what you need to get to the point
18:55here okay you can see all the math in
18:56the books you don't need me to walk you
18:58through every ma mathematical scenario
19:00but what we're saying here is we're
19:01comparing a firm that is equity financed
19:03100% Equity financed to what would
19:05happen to that same firm if who was not
19:06100% Equity Finance but financed 50%
19:09with debt and 50% with equity and what
19:11we're going to see is under both
19:13scenarios if the if the firm
19:16increases their eBid by 10% if it's all
19:18Equity financed and they increase their
19:20eBid by 10% or decreases the ebit by 10%
19:24then the Roe will also change by the
19:26same amount as the ebit but if the firm
19:28is not 100% financed with Equity if it's
19:32not 100% financed with Equity it's
19:33financed partially with debt and Equity
19:35what we're going to see is that
19:37increasing the amount of debt in the
19:38firm's capital structure is going to
19:40create a situation where Roe is
19:42increasing the level of Roe is
19:44increasing and it's going to be higher
19:46than the Roe of the 100% Equity Finance
19:49situation but not only the the the uh
19:52the level of Roe but also the rate of
19:54change of the Roe from ebit increasing
19:57by 10% and ebit decreasing by
20:0010% so that's the key Point remember is
20:02both the level and the rate of change of
20:04Roe will increase so for example in an
20:07unleveraged scenario the as I just
20:09mentioned the Roe is going to vary
20:11directly with the change in ebit so if
20:13we're going to assume a certain
20:14situation then we're going to increase
20:16eBid by 10% or decrease eBid by 10% and
20:18we're all 100% Equity financed then the
20:21Roe will also increase by 10% or
20:23decrease by 10% just like the
20:26ebit okay and then uh in in a leverage
20:29scenario the Roe is just simply going to
20:31become more volatile for an increase in
20:33ebit for example of 10% and then a
20:35decrease in 10% the Roe is going to
20:38increase the level of the Roe is going
20:40to be higher than it was in the O Equity
20:42Finance situation but again as I'm as I
20:44said before also the rate of change of
20:47the Roe will be greater it's going to be
20:49much more
20:50volatile so the use of financial
20:52leverage increases obviously the risk of
20:54default but also increases the potential
20:57return to the equity holders but the
20:58equity holders are going to perceive
21:00that higher level of debt as more risky
21:02to their future you know profits okay so
21:05that's the key point to keep in mind
21:07there now the next section which is
21:09pretty much the uh last couple of uh
21:11learning outcome statements of this
21:12reading now I'm
21:14on in the curriculum readings is to
21:17calculate the break even quantity of
21:19sales and determine the company's net
21:21income at various sales levels and to
21:24calculate and interpret the operating
21:27break even quantity of sales so if you
21:30look at these two learning outcome
21:31statements very carefully there's a
21:32difference the first one is asking you
21:34to come up with the overall Break Even
21:37quantity of sales that would cover what
21:38all fixed costs all fixed operating
21:40costs and all fixed Financial costs
21:43whereas the second requirement is to be
21:45able to calculate the operating Break
21:48Even quantity of sales and that is the
21:50quantity of sales that we would break
21:51even from an operating standpoint
21:53meaning just it just covers fixed
21:55operating costs not fixed financing
21:57costs so we're going to talk about this
21:59very
22:00carefully so when we talk about the
22:02break even quantity of sales we're
22:04saying well what is the level of sales
22:08that the firm would have to produce in
22:11order to cover all of its fixed
22:13operating costs and all of its fixed
22:15financing costs in other words The Firm
22:16has two types of fixed costs operating
22:19and and financial costs so we're saying
22:22what is the level of sales that they
22:24would have to cover all their fixed
22:25costs operating and financi
22:28in other words what is the level of
22:31sales that the firm would have to
22:33produce so the net income is equal to
22:36zero so that when they cover all of
22:38their costs their net income is equal to
22:40zero so if you take a look at your
22:42screen now you will see that the formula
22:44is for the break even quantity of sales
22:46it would be all of my fixed cost my
22:48fixed operating cost and my fixed
22:50financing cost and then I would divide
22:52that by the contribution margin what is
22:55the contribution margin the price per
22:57per unit minus the variable cost per
22:59unit that is called the contribution
23:02margin that is a must know
23:05formula okay now that is to be
23:08distinguished from the operating or
23:11calculating the operating Break Even
23:13quantity of sales now operating always
23:15means what on the income statement ebit
23:17so I'd like to know what is the break
23:19what is the level of sales that the firm
23:21would have to produce so that ebit not
23:24net income but ebit is equal to zero so
23:28that's what we call so we would be just
23:29covering our fixed operating costs and
23:32ignoring our fixed financing costs so
23:35therefore our formula for the break even
23:37operating Break Even quantity of sales
23:39the operating Break Even quantity of
23:40sales would be the fixed operating cost
23:42divided by that contribution margin of
23:45price per unit minus variable cost per
23:47unit so to summarize here a firm that
23:51actually chooses operating and financial
23:54structures that result in a higher
23:56degree of total fixed cost is going to
23:59have a higher break even total Break
24:01Even quantity of sales so if they want
24:04to cover both their fixed costs or it's
24:06any kind of actions that they take
24:07that's going to increase their total
24:08fixed cost in general they're going to
24:10need to produce even more units to cover
24:12all of those fixed costs because they
24:14have to cover again both fixed C fixed
24:15operating cost and fixed financing costs
24:18and these same conclusions also apply to
24:21operating leverage and the operating
24:23Break Even quantity of sales one company
24:25can actually choose a lot larger scale
24:28of operations in other words they want
24:29to create a larger firm or a larger
24:32Factory or a larger entity and that's
24:34going to result in a greater operating
24:37Break Even quantity of sales and greater
24:39leverage why because as they are larger
24:41as they get larger they have more cost
24:43to to cover and because they have more
24:45cost to cover that's going to increase
24:47their they're going to have to increase
24:49the amount of sales that they make in
24:50order to cover those costs that is the
24:53idea that you need to know behind this
24:54reading on measures of Leverage so don't
24:57don't don't make the mistake of of uh
24:59confusing operating Break Even quantity
25:01of sales and the total Break Even
25:03quantity of sales and now what we're
25:04going to do is we're going to do a
25:06problem okay what I think would be very
25:08helpful now is to do this problem and
25:10we're going to go over all the parts
25:12okay for this so this is uh uh a story
25:16with Mike branth so Mike branth has just
25:18read an announcement from Wade goods and
25:20company that the carry com was put into
25:23production at the beginning of
25:262004 the announcement in includes the
25:28information given in exhibit 5-1 okay
25:32and it shows you the unit sales the
25:34sales price per unit and the total
25:36revenues so obviously you take the unit
25:38sales in 2004 of 5 million that's equal
25:40to what unit sales would be sales price
25:42per unit of 100 times the total revenues
25:45of $500 so $500 time five times
25:49um 100 would give you the number there
25:53okay in any case with respect to the
25:54carry com
25:56forecast um
25:58excuse me that that's the unit sales I'm
26:00sorry I misread that the unit sales is
26:01five minute five million the sales price
26:03per unit is $100 and the total revenues
26:06are $500 I apologize that's my misread
26:08that's not $5 million just 5 million
26:10units excuse me so it's not a big deal
26:12with respect to the carryon forecast for
26:142004 brandworthy operating fixed cost
26:18will be 225 and the operating variable
26:21cost will be 27.5% of the sales price so
26:25the question in part A is to calculate
26:28the carry com's Break Even sales
26:31quantity for 2004 show your calculations
26:34so we're going to focus on 2004 now they
26:37did ask for the break even quantity of
26:39sales are they asking for the operating
26:42Break Even quantity of sales or the
26:45total Break Even quantity of sales well
26:48in this particular problem both the
26:51total Break Even quantity of sales and
26:53the operating Break Even quantity of
26:55sales would be the same
26:58why would be the same because they don't
26:59have any fixed financing cost they only
27:01have operating fixed costs they only
27:03have fixed operating cost they don't
27:05have any fixed financing cost so the
27:06total financing fixed cost would be zero
27:09so it would be one and the same so you
27:10could have used either formula but
27:13because they said Break Even quantity of
27:14sales I would have just done the total
27:16Break Even quantity of sales and we know
27:18that that's going to be the total fixed
27:21operating costs plus the total fixed
27:23financing cost over the contribution
27:25margin which is sales price per unit
27:28minus variable cost per unit now I'm
27:31going to give you a moment to do that
27:33and then you can come back and we can go
27:34over the answer and make sure that you
27:36got the correct answer so go ahead you
27:38can put me on pause for a second and
27:40come
27:42back okay if you come back now if you
27:44came back and you've done this you
27:46should have gotten that the break even
27:48quantity of sales for 2004 is drum roll
27:523,1
27:55103,4 48 you units okay you know just
27:59rounded it was 3,1 103,4 48 units okay
28:03how did we get that well what are our
28:05total fixed costs our total fixed costs
28:07are 225 million which are really our
28:10total fixed operating costs our total
28:12fixed financing costs are zero so
28:14therefore the total fixed costs are
28:16still 225 million that would be the
28:19numerator of our calculation and then we
28:22would divide it by the contribution
28:24margin which is the sales price per unit
28:26which is 100 minus the variable cost per
28:29unit and you were told that the
28:30operating variable cost per units are 27
28:3327.5% of the sales price since the sales
28:36price is 100 275% of that would be 27.5
28:40or 2750 so in other words we would have
28:43$225 million of total fixed cost in the
28:46numerator divided by $100 minus
28:50$27.50 and therefore if we put divide
28:52the the denominator by the numerator
28:54into the numerator we get
28:563,134 48 that would be your break even
28:59now you have your my calculation showing
29:01in front of you and you also have you'll
29:04and I'll put up the answer key
29:05afterwards but you have my calculation
29:07right now and at the end when we finish
29:09this problem we'll put up the official
29:10answer
29:11key all right let's move on to the uh
29:14next part of this
29:17question which is if we take a look at
29:19the second page Part B says in number
29:23one I want you to calculate the degree
29:26of operating Leverage for Wade in 2005
29:30be careful this is exactly what you need
29:32to be careful about on the exam people
29:34are studying for this exam but a lot of
29:36the distinction between papers is
29:38reading ability and what was the last
29:40problem doing calculating the break even
29:43quantity of sales in which year 2004 now
29:46they switched it two uh coming up with
29:48the op doing the operating leverage for
29:502005 you got to make sure that you're
29:52looking at the right ears and then show
29:54your
29:55calculations and then in the second part
29:57it's it's asking you to judge whether
29:59the operating income of Wade or dynamic
30:01would be more affected by the change in
30:03revenues
30:05in5 justify your response with reference
30:07to the degree of operating leverage in
30:102005 for each company so now if we go
30:13back to the previous page okay we're
30:17going to now read the story under letter
30:19A which says 6 months later brandreth
30:24reviews industry data for the first half
30:26of 20 04 that indicates a slowing growth
30:30rate in sales branth has prepared
30:33revised projections for 2005 for both
30:36Wade and dynamic communication selected
30:40data from his revised projections for
30:41Wade are shown in exhibit 5-2 which is
30:45right
30:45below branth is using his revised data
30:49to analyze the extent to which both Wade
30:51and dynamic are using operating leverage
30:54and financial leverage for a dynamic
30:56he's calculated the direct the degree of
30:59operating leverage this is for dynamic
31:01he's calculated the degree of operating
31:02leverage in 2005 to be 2.41 and the
31:06degree of financial leverage for dynamic
31:08to be
31:091.17 but what was the question asking if
31:12we take a look at the question which is
31:13also appearing again on your screen for
31:16Part B only it's to calculate the degree
31:18of operating leverage for whom for Wade
31:21and justify whether Wade or dynamic
31:23would have the or be more affected by a
31:25change in revenues in 2005
31:27so if we go if we're now looking at that
31:29same exhibit 5-2 what I'd like you to do
31:32is I'd like you to actually calculate
31:34the degree of operating
31:36leverage in 2005 for Wade and then what
31:40I'd like you to do is answer Part B
31:41about who would be more or who would be
31:43more impacted by a change in
31:46sales so you can put me on pause for a
31:50about 45 seconds and then come back and
31:51let's go over
31:53it okay if you C come back if you've
31:56done the calcul
31:57you should have that the degree of
31:59operating Leverage is
32:011.85 for Wade how did we get that well
32:05how do we calculate the degree of
32:07operating leverage we saw that there
32:08were different formulas for the degree
32:10of operating leverage one of them was
32:11the percentage change in
32:14ebit divided by the percentage change in
32:17sales but that would not be applicable
32:19here because we don't have two years
32:20worth of data we only have 2005 here
32:23income statement so we can't do that
32:25then the other formula was say Sal minus
32:28total variable cost divided by sales
32:30minus total variable cost minus fixed
32:32cost we have that here on the income
32:35statement and then the third formula was
32:36just the same formula about just using
32:38quantity times price per unit minus
32:40variable cost per unit so what I would
32:42have done is I would have used the
32:43second formula and said okay what's my
32:46sales my sales is
32:48590 I would subtract 210 for my
32:52operating variable cost that would be my
32:53numerator for calculating the degree of
32:55operating Leverage and then I would
32:57divide that by 590 minus 210 minus my
33:00operating fixed cost of
33:03175 and if I do that I would get
33:061.85 as my degree of operating leverage
33:09so you could see that now on the answer
33:11key that I'm putting up right the second
33:13formula for Part B number one so now we
33:15know the degree of operating leverage
33:17for weight is
33:191.85 now the second part of the question
33:21asked you well who would be more
33:23impacted by a change in revenues and
33:26your answer should be
33:27Dynamics operating income would be more
33:30affected by a change in Revenue in 2005
33:33why because what was Dynamics degree of
33:36operating leverage it's right above
33:37exhibit 5-2 in the sentence right above
33:40exhibit 5-2 it shows you that uh
33:44dynamic's degree of operating leverage
33:45in 2005 was 2.41 and that is
33:48substantially higher than Wade's degree
33:50of operating leverage which we just
33:51calculated was 1.85 so Dynamics
33:54operating income would be more affected
33:56by a change in Revenue that would be the
33:58response that you would need for Part B
34:00number two now remember on the level one
34:02exam you're not going to have to write
34:03anything except what Circle a b and c
34:05and they could have done this as a two
34:07column question they could have said
34:08okay what's the degree of operating
34:10leverage and then ABC and then right
34:12next to that who's affected more dynamic
34:15or Wade and so they could do this as a
34:18two column answer so keep that in mind
34:21now let's move on to part C part C is
34:25asking you again to calc calate the
34:27degree of financial leverage for weight
34:30in 2005 and show your calculations and
34:34then again judge whether weade or
34:37dynamic would have more Financial Risk
34:39in 2005 and then justify your response
34:42with reference to the degree of
34:44financial leverage in 2005 for each
34:47company okay so we're going to keep that
34:50question up there so that you could see
34:51it and then we're going to go back to
34:53that same exhibit that exhibit 5-2 okay
34:58and we're going to be do and we're going
34:59to answer question for part C to come up
35:01with a degree of financial leverage now
35:03the degree of I'm going to give you 45
35:05seconds to do the degree of financial
35:06leverage and then we will come back so
35:08you can put me on pause again and
35:10calculate
35:13it okay if you calculated the degree of
35:16financial leverage for Wade in 2005
35:18using the exhibit 5-2 that income
35:21statement you should have come up with
35:221.66 or
35:241.67 something around there how do we
35:27calculate the degree of financial
35:29leverage the degree of financial
35:30leverage there's two formulas the
35:32percentage change in earnings per share
35:34divided by the percentage change in ebit
35:36if we're reading again up the income
35:38statement but again we can't do that
35:40formula because we don't have two years
35:41worth of data here so we need to use the
35:43other formula which
35:45is which is going to be the ebit over
35:48ebit minus interest expense ebit do we
35:51have yes you are told ebit it's right
35:53there operating income ebit is 205 so
35:55it's going to be 205 divided by 205
35:58minus interest expense of 82 and that
36:00would give you the 1.67 that we just
36:03calculated again now you have part C my
36:05for my my uh calculation run right in
36:07front of you you have my written
36:09calculation right in front of you that
36:10shows you
36:121.67 okay and then we're going to answer
36:14the second part of the question which is
36:15to judge who has more Financial Risk and
36:18you should have come up with Wade Wade
36:20would have more Financial Risk in 2005
36:23because its degree of financial leverage
36:25which we just calculated is 1. 67 is
36:27much higher than Dynamics which you were
36:30told again right above exhibit 5-2 right
36:33above exhibit 5-2 in that sentence it
36:35says the degree of financial leverage
36:37for weade excuse me for dynamic is
36:401.17 so since Wade has a Financial Risk
36:45or financial leverage a degree of
36:46financial leverage of 1.67 that is
36:49substantially higher than Dynamics 1.17
36:52so therefore Wade Wade has a higher
36:54degree of financial grow risk or
36:57financial
36:59leverage okay moving on to the last part
37:01of this question Part D which is pretty
37:04easy calculate the degree of total
37:07leverage for dynamic in 2005 show your
37:11calculation I'll give you 45 seconds to
37:14do this again we're going to put up the
37:15income statement for you for Wade so you
37:17have exhibit 5-2 in front of you and I
37:19want you to calculate the degree of
37:21total average and come up with the
37:24answer okay you can put me on pawns 4 5
37:26seconds and come
37:29back okay if you've done this the degree
37:31of total leverage you should have gotten
37:33is 2.82 or 2.81 97 2.82 if you didn't
37:39get that answer you didn't read the
37:40question very carefully what does
37:43question D say question D part D says
37:48calculate the degree of total leverage
37:49of whom of
37:51whom of dynamic not Wade what was Part B
37:56and C focusing on you doing the
37:58calculations for Wade now in part D they
38:00switched the name and wanted you to do
38:02the calculation for dynamic so you had
38:05to use the numbers for dynamic now the
38:07numbers for dynamic if you're if you
38:09look at the uh right above exhibit 5-2
38:12those two lines right above exhibit 5-2
38:15you were told that the degree of
38:16operating leverage was
38:182.41 for dynamic and the degree of
38:21financial leverage was
38:241.17 so therefore when you multiply the
38:27degree of operating leverage by the
38:28degree of financial leverage you get the
38:29degree of total leverage so 2.41 * 1.17
38:34gives you 2.82 you can see my
38:36calculations right there okay for Part D
38:40and then now what we're going to do is
38:41if you understood this we're going to
38:42put up the official answer key and you
38:45can put up the going to put up the
38:46official answer key so you could see
38:47part A B C and D for this question and
38:50this concludes everything that I wanted
38:53to do on this reading on measures of
38:55Leverage

About this transcript

This page contains the full transcript of CFA Level 1 Free Lesson: Financial Leverage, Operating Leverage, Total Leverage & Breakeven Sales by Chalk & Board, generated from the public captions YouTube serves with the video. The transcript has 7,300 words across 1,055 segments, with the original timestamps preserved so you can click any line to jump to that moment in the embedded player.

What you can do with it

Use the transcript to take notes, quote the speaker, build a study guide, generate a summary with ChatGPT or Claude via the YouTube Summary tool, or export it as a timed subtitle file with YouTube to SRT. You can also re-open it in the transcriber to translate the transcript into 100+ languages.

Free YouTube transcript tool

YouTube2Text is a free YouTube transcript generator — no signup, no daily limit. Paste any YouTube link and get the full transcript instantly, with timestamps, click-to-jump, translation to 100+ languages, AI prompts for ChatGPT, Claude, and Gemini, and exports to TXT, SRT, VTT, or Markdown.