Leverage
The use of debt to finance assets — magnifying both returns on equity and the risk borne by equity holders.
The exam loves the degree-of-leverage formulas: DOL = %ΔEBIT / %Δsales (or contribution margin / EBIT), DFL = %ΔEPS / %ΔEBIT (or EBIT / [EBIT − interest]), and DTL = DOL × DFL. A classic vignette gives sales, fixed costs, and interest, then asks for the percentage change in EPS from a given change in revenue — answer it by multiplying through DTL. The “tell” is which leverage is in play: if the trigger is operating cost structure, it’s DOL; if it’s debt and interest, it’s DFL. Higher fixed costs raise DOL; more debt (interest) raises DFL.
Don’t confuse leverage with solvency, which measures the debt load through ratios (debt-to-equity, interest coverage); leverage is the underlying use of that debt. And leverage is not the same as liabilities — operating leverage comes from fixed costs, not borrowing, so a firm can carry high operating leverage with little debt. Memory hook: operating = the cost line, financial = the debt line — DOL acts above interest expense on the income statement, DFL below it.
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