Page 173 - DMGT207_MANAGEMENT_OF_FINANCES

Management of Finances

Notes corresponding direction. At this point, it should be clear that whenever a firm has fixed units,
operating or financial, in its structure, combined leverage would exist.

Impact of Turnover and Capital Turnover Ratio and Working Capital Ratio

An increase in sales improves the net profit ratio, raising the Ratio On Investment (ROI) to a
higher level. One may wonder that it will be very attractive for the management to try to raise
their capital turnover ratio without restrain. This is not preferable in all situations; since a rise
in capital turnover must be supported by an adequate capital base i.e., working capital.
The main reason for a fall in ratio showing the working capital position due to increase in
turnover rates is that as the activity increases without a corresponding rise in working capital,
the working capital position becomes tight. As the sales increase, both the current assets and
current liabilities also increase, but not in direct proportion to the current ratio.

If the current ratio is to be maintained at 2, each increase in sales must result in a two-fold rise in
the current assets as compared to current liabilities. But, this does not happen with the same
amount of funds, hence a fall in the current ration.

!
Caution It needs to be ensured that when capital turnover ratio is sought to be increased,
its effect on the working capital situation is to be carefully considered.
If the current ratio and the acid test ratio are high, it is apparent that the capital turnover ratio can
be increased without any problem. However, it may be very risky to increase capital turnover
ratio when the working capital position is not satisfactory.

Self Assessment

Fill in the blanks:
12. Combined leverage is equals to …...........………… leverage multiplied by financial leverage.

13. Combined leverage is viewed as the total impact of the ………………… cost in the firms
operating and financial structure.
14. A high operating leverage and a high financial leverage combination is………………… .

15. The ………………… nature of the leverage relationship accounts for the fact that sales
charges of equal magnitude in opposite directions results in EPS charges of equal magnitude
in the corresponding direction.

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Case Study RKV – Leverage

T his case provides the reader with the opportunity to apply different concepts of
leverage to the planning process of the firm.
RKV is an important manufacturer of swimming pools. The firm is located in a semi-
urban area. The firm’s primary markets are hardware and discount stores located in five
Northeastern states. Lucid products reach its market mostly by truck.
Contd...

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