“One type of leverage affects both EBIT and EPS. The other type affects only EPS.” Explain this statement.

“One type of leverage affects both EBIT and EPS. The other type affects only EPS.” Explain this statement.

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June 22, 2021
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“One type of leverage affects both EBIT and EPS. The other type affects only EPS.” Explain this statement.

Answer and ExplanationSolution by a verified expert

Explanation

The two major types of leverage are operating leverage and financial leverage. Operating leverage relates to extent to which the fixed costs are used in the operations of firm whereas financial leverage relates to the extent to which the fixed-income securities such as preferred stock and debt are used in the capital structure of a firm.
Earnings before interest and taxes(EBIT) is one the ways of determining the profitability of a company. It is usually calculated by subtracting the operating expenses from the company's revenue.  It is the net income with the taxes and interest added back and represents the overall profit.
Earnings per share(EPS) on the other hand is also a way of determining the profitability of a company and it indicates amount of profit which is allocated to every outstanding share. It is calculated by subtracting the dividends on the preferred stock from the net income and then divide the result by average number of the shares outstanding.
As seen above, EBIT and EPS rely on a form of net income and thus the leverage which affects both indicators is net income. EBIT use the net income with the interest and taxes added back whereas EPS uses net income. This therefore mean that changes in operating leverage will affect both EBIT and EPS. However, the financial leverage of a firm affects only EPS with EBIT remaining the same.

Answer

Operating leverage affects EBIT and through EBIT, it also affects EPS. Financial on the other hand has no effect on EBIT but only affects EPS when EBIT is given.

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