DOL
The Degree of Operating Leverage (DOL) is the
leverage ratio that sums up the effect of an
amount of operating leverage on the companys
earnings before interests and taxes (EBIT).
Operating Leverage takes into account the
proportion of fixed costs to variable costs in the
operations of a business. If the degree of
operating leverage is high, it means that the
earnings before interest and taxes would be
unpredictable for the company, even if all the
other factors remain the same.
Formula for determining Degree of Operating
Leverage
The formula used for determining the Degree of
Operating Leverage or DOL is as follows:
DOL = % Change in EBIT / % Change in Sales
The Degree of Operating Leverage Ratio helps a
company in understanding the effects of
operating leverage on the companys probable
earnings. It is also important in determining a
suitable level of operating leverage which can be
used in order to get the most out of the
companys Earnings before interest and taxes or
EBIT.
If the operating leverage is high, then a smallest
percentage change in sales can increase the net
operating income. The net operating income is
the amount of income that is left after payments
of fixed cost are made, regardless of how much
sales has been made. Since the Degree of
Operating Leverage or DOL helps in determining
how the change in sales volume would affect the
profits of the company, it is important to
ascertain the value of degree of operating
leverage in order to minimize the losses to the
company.
A business would benefit if the can estimate the
Degree of Operating Leverage or DOL. The impact
of the leverage on the percentage of sales can be
quite striking if not taken seriously; therefore it is
really important to minimize these risks of the
business. If you get a higher degree of operating
leverage or DOL then you should try and balance
the operating leverage to balance with the
financial leverage in order to provide with profits
to the company. A companys balance Degree of
Operating Leverage can provide the financial
DFL
The degree of financial leverage (DFL) is the
leverage ratio that sums up the effect of an
amount of financial leverage on the earning per
share of a company. The degree of financial
leverage or DFL makes use of fixed cost to
provide finance to the firm and also includes the
expenses before interest and taxes. If the Degree
of Financial Leverage is high, the Earnings Per
Share or EPS would be more unpredictable while
all other factors would remain the same.
The Degree of Financial Leverage (DFL) can be
calculated with the following formula:
DFL = % Change in EPS / % Change in EBIT
Where EPS is the Earnings per Share and EBIT is
the Earnings before interest and Taxes.
The degree of financial leverage or DFL helps in
calculating the comparative change in net income
caused by a change in the capital structure of
business. This ratio would help in determining the
fate of net income of the business. This ratio also
helps in determining the suitable financial
leverage which is to be used to achieve the
business goal. The higher the leverage of the
company, the more risk it has, and a business
should try and balance it as leverage is similar to
having a debt.
This formula can be even used to compare data
of many companies that can help an investor in
deciding which company to invest in, based on
the result of how much risk is attached with each
companies capital structures. It would help an
investor to strike a great deal as when the there
is an economic decline the losses of the company
can be substantiated with this investment and
during the rise in the economic conditions the
volume of sales would be well compensated.
The degree of financial leverage is useful for
figuring out the fate of net income in the future,
which is based on the changes that take place in
the interest rates, taxes, operating expenses and
other financial factors. Debts added to a business
would provide an interest expense to the
company which is a fixed cost, and this is when
the companys business begins to turn to provide
profit. It is important to balance the financial
leverage according to the operating costs of the
leverage is an important factor contributing to
business profits. Even a small percentage of
increase in sales can help in having a greater
proportion of profits in the company, so it is
really important to maintain a balance between
both financial leverage and operating leverage to
yield maximum benefits.
Operating leverage refers to the percentage of
fixed costs that a company has. Stated another
way, operating leverage is the ratio of fixed costs
to variable costs. If a business firm has a lot of
fixed costs as compared to variable costs, then
the firm is said to have high operating leverage.
These firms use a lot of fixed costs in their
business and are capital intensive firms.
A good example of capital intensive business firm
are the automobile manufacturing companies.
They have a huge amount of equipment that is
required to manufacture their product -
automobiles.
When the economy slows down and fewer
people are buying new cars, the auto companies
still have to pay their fixed costs such as
overhead on the plants that house the
equipment, depreciation on the equipment, and
other fixed costs associated with a capital
intensive firm. An economic slowdown will hurt a
capital intensive firm much more than a company
not quite so capital intensive.
company as it would minimize the level of risks
involved.
Financial leverage refers to the amount of debt in
the capital structure of the business firm. If you
can envision a balance sheet, financial leverage
refers to the right-hand side of the balance sheet.
Operating leverage refers to the left-hand side of
the balance sheet - the plant and equipment side.
Operating leverage determines the mix of fixed
assets or plant and equipment used by the
business firm. Financial leverage refers to how
the firm will pay for it or how the operation will
be financed.
As discussed earlier in this article, the use of
financial leverage, or debt, in financing a firm's
operations, can really improve the firm's return
on equity and earnings per share. This is because
the firm is not diluting the owner's earnings by
using equity financing. Too much financial
leverage, however, can lead to the risk of default
and bankruptcy.

You can compare the operating leverage for a

capital intensive firm, which would be high, to
the operating leverage for a labor intensive firm,
which would be lower. A labor intensive firm is
one in which more human capital is required in
the production process. Mining is considered
labor intensive because much of the money
involved in mining goes to paying the workers.
Service companies that make up much of our
economy, such as restaurants or hotels, are labor
intensive as well. They all require more labor in
the production process than capital costs.
In difficult economic times, firms that are labor
intensive typically have an easier time surviving
than capital intensive firms.

What does operating leverage really mean? It

means that if a firm has high operating leverage,
a small change in sales volume results in a large
change in EBIT and ROIC, return on invested
capital. In other words, firms with high operating
leverage are very sensitive to changes in sales
and it affects their bottom line quickly.
It is fully based on fixed cost. So, the higher the
fixed cost of the company the higher will be the
Break Even Point (BEP). In this way, the Margin of
Safety and Profits of the company will be low
which reflects that the business risk is higher.
Therefore, low DOL is preferred because it leads
to low business risk.
The DFL is based on interest and financial
charges, if these costs are higher DFL will also be
higher which will ultimately give rise to the
financial risk of the company. If Return on Capital
Employed > Return on debt, then the use of debt
financing will be justified because, in this case,
the DFL will be considered favorable for the
company. As the interest remains constant, a
little increase in the EBIT of the company will lead
to a higher increase in the earnings of the
shareholders which is determined by the financial
leverage. Hence, high DFL is suitable.

Operating leverage and financial leverage both magnify the changes that occur to earnings due to
fixed costs in a companys capital structures. Operating leverage magnifies changes in earnings before
interest and taxes (EBIT) as a response to changes in sales when a company's operational costs are
relatively fixed. Financial leverage magnifies how earnings per share (EPS) change as a response to
changes in EBIT where the fixed cost is that of financing, specifically interest costs.

Businesses with higher ratios of fixed costs to variable costs are characterized as using more operating
leverage, while businesses with lower ratios of fixed costs to variable costs use less operating
leverage. Utilizing a higher degree of operating leverage increases the risk of cash flow problems
resulting from errors in forecasts of future sales.

Earnings per share become more volatile when the DFL is higher. Financial leverage magnifies
earnings per share and returns because interest is a fixed cost. When a company's revenues and
profits are on the rise, this leverage works very favorably for the company and for investors. However,
when revenues or profits are pressured or falling, the exponential effects of leverage can become
problematic.
While operating leverage delineates the effect of change in sales on the companys operating earning,
financial leverage reflects the change in EBIT on EPS level.
Low operating leverage is preferred because higher DOL will cause high BEP and low profits. On the
other hand, High DFL is best because a slight rise in EBIT will cause a greater rise in shareholder
earnings, only when the ROCE is greater than the after-tax cost of debt.