AE 19 Operating and Financial Leverage

AE19-FINANCIAL MANAGEMENT
ANALYSIS OF FINANCIAL STATEMENTS
A. OPERATING LEVERAGE
Operating leverage is a concept in finance that measures the extent to which the company's costs are made up of fixed c
as opposed to variable costs. It's a measure of how a company's operating income responds to changes in sales volume
Operating leverage acts as a multiplier. If operating leverage is high, a small percentage increase in sales can produce a
larger increase In net operating income.
Degree of Operating Leverage (DOL) is computed using the following formula.

Contribution margin
Degree of operating leverage = Net operating income
ILLUSTRATION:
GREEN FARM YELLOW FARM
Actual Budgeted Acutal
Sales 1,000,000 1,100,000 1,000,000
Variable Expenses 600,000 660,000 300,000
Contribution Margin 400,000 440,000 700,000
Fixed expenses 300,000 300,000 600,000
Net operating income 100,000 140,000 100,000
DOL for Green Company: 400,000/100,000 = 4 DOL for Yellow Company: 700,000/100,000 = 7
Because the DOL for Green Farm is 4, the farm's net operating income grows four times (4x) as fast as its sales. In contr
Yellow Farm's net operating income grows seven times (7x) as fast as its sales. Thus, if sales increase by 10%,
% increase in DOL % increase in Net
Sales Operating income
Green Farm 10% 4 40%

Yellow Farm 10% 7 70%
LIMITATIONS OF ANALYSIS: in using operating leverage, it is assumed that a constant or linear function exists for revenu
costs as volume changes. For example, P200 was used as hypothetical sales price at all levels of operation. "In the real
however, a firm may reduce price in an attempt to capture a larger market for its product. This means relationships are
fixed as have been assumed.
ACTIVITY: OPERATING LEVERAGE/CVP RELATIONSHIP

ABC Company manufactures and sells a specialized cordless telephone for high electromagnetic radiation environments.
company's contribution format income statement for the most recent year is given below:
Total Per unit % of sales
Sales (20,000 units) 1,200,000 P60 100%
Variable expenses 900,000 45 ?
Contribution margin 300,000 P15 ?
Fixed expenses 240,000
Net income 60,000
1) Compute for the company's BEP in both units and sales in pesos.
2) Assume that sales increase by P400,000 next year. If cost behavior patterns remain unchanged, by how much will the
net operating income increase?
3) Assume that next year, management wants the company to earn a profit of P90,000. How many units will have to be
meet the target profit?
4) a) Compute the degree of operating leverage at the present level of sales.
b) Assume that through a more intense effort by the sales staff, the company's sales increase by 8% next year. By wh
percentage is net income expected to increase?
c) Verify your answer to (b) by preparing a new contribution format income statement showing an 8% increase in sales
5) In an effort to increase sales and profits, management is considering the use of high-quality speaker. The higher-quali
speaker would increase variable costs by P3 per unit, but management could eliminate one quality inspector who is paid
salary of P30,000 per year. The sales manager estimates that the higher-quality speaker would increase annual sales by
least 20%.
a) Assuming that changes are made as described above, prepare a projected contribution format income statement for
next year. Show data on a total, per unit and percentage basis.
b) Compute the company's new break-even point in both units and peso sales.
c) Would you recommend that changes be implemented?
B. FINANCIAL LEVERAGE (TRADING ON EQUITY)

Financial leverage reflects the amount of debt used in the capital structure of a firm. It is the strategic endeavor of borro
money to invest in assets. The goal is to have the return (margin) on those assets exceed the cost of borrowing the fund
goal of financial leverage is to increase profitability without using additional capital.
The two most common financial leverage ratios are: 1) debt-to-equity (total debt/total equity)
2) debt-to-assets ratio (total debt/total assets)
It ios advisable to trade on equity when earnings from borrowed funds exceed the cost of borrowing.
- as leverage increases, the risk borne by creditors as well as the risk that the firm may not be able to meet its maturi
obligations increases.
- since interest expense is tax deductible, leverage increases the company's profit/rturn when it is profitable.
Degree of Financial Leverage = Percentage change in EPS
Percentage change in EBIT
Limiotations in the use of Financial Leverage:

Debt financing and financial leverage offer unique advantages, but only up to a point that debt financing ma
detrimental to a firm. For example, as the use of debt is expanded in the capital structure, lenders may perceive a great
risk for the firm. For that reason, they may raise the average interest to be paid and they may demand that certain restr
on the firm. The impact of financial leverage must be carefully weighed by firms with high debt.
Exercises:
1) Which of the following is not a key determinant of financial leverage?
a) technology b) cost of debt c)_ level of deby d) capital structure
2) Which of the following situations is likely to have the highest combined business and financial risk impact upon a busines
a) a fully automated plant is completed, funded with retained earnings
b) a new labor intensive operation is funded with operating cash flow
c) a fully automated plant is completed, funded with the issuance of 10-year bonds
d) an automated plant in the southern region is closed and operations are resumed in a labor-intensive plant in Central L
3) ABC Company has developed a new fantasy board game. The company sold 15,000 games last year at a selling price of
game. Fixed costs associated with the game amounted to P1,820,000 per year, and variable costs are P60 per game. Pr
of the game is entrusted to a printing contractor. Variable costs consists mainly of payments to the contractor.
a) Prepare a contribution format income statement for the game last year and compute DOL.
b) Mangement is confident that the company can sell 18,000 games next year. Compute for:
1) the expected percentage increase in net operating income for next year
2) the expected total peso net operating income for next year.(Do not prepare an income statement; use DOL to compute
answer).
re made up of fixed costs,
anges in sales volume.
n sales can produce a much
ELLOW FARM
Budgeted
1,100,000
330,000
770,000
600,000
170,000
as its sales. In contract,

se by 10%,
tion exists for revenues and

peration. "In the real world",
ans relationships are not as
iation environments. The
by how much will the company's
units will have to be sold to
8% next year. By what

8% increase in sales.
ker. The higher-quality

nspector who is paid a
ease annual sales by at
come statement for
gic endeavor of borrowing

of borrowing the funds. The
ble to meet its maturing
s profitable.
hat debt financing may be

may perceive a greater financial
and that certain restrictions
mpact upon a business?
ive plant in Central Luzon.

r at a selling price of P200 per
are P60 per game. Production
contractor.
; use DOL to compute the

AE 19 Operating and Financial Leverage

Uploaded by

Copyright:

Available Formats

AE 19 Operating and Financial Leverage

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

AE 19 Operating and Financial Leverage

Uploaded by

Copyright:

Available Formats

AE19-FINANCIAL MANAGEMENT

ANALYSIS OF FINANCIAL STATEMENTS

Degree of Operating Leverage (DOL) is computed using the following formula.

Green Farm 10% 4 40%

ACTIVITY: OPERATING LEVERAGE/CVP RELATIONSHIP

B. FINANCIAL LEVERAGE (TRADING ON EQUITY)

Limiotations in the use of Financial Leverage:

as its sales. In contract,

tion exists for revenues and

iation environments. The

by how much will the company's

units will have to be sold to

8% next year. By what

ker. The higher-quality

come statement for

gic endeavor of borrowing

ble to meet its maturing

hat debt financing may be

mpact upon a business?

ive plant in Central Luzon.

; use DOL to compute the

You might also like