Page 153 - DMGT405_FINANCIAL%20MANAGEMENT

Unit 8: Concept of Leverages

operating leverage and a high financial leverage. A low operating leverage implies that the company Notes
reaches its breakeven point at a low level of sales. Therefore, risk is diminished. A highly cautious
and conservative manager will keep both its operating and financial leverage at a very low level, but
the approach may, however, mean that the company is losing profitable opportunities.

Example: Cable Company, a computer cable manufacturer expects sales of 20,000 units
@ 50 per unit in the coming year and must meet the following obligations: Variable operating
costs of 20 per unit, fixed operating costs of 100,000, interest of 200,000 as preferred stock
dividends of 120,000. The firm is in the 40% tax bracket and has 50,000 of equity shares
outstanding. If we present the levels of earnings per share associated with the expected sales of
20,000 units as with sales of 30,000 units, it will look as below:

= 50%
Sales in units 20,000 30,000 Operating leverage
Sales revenue 10,00,000 15,00,000 + 60%
=
Less variable operating costs 400,000 600,000 + 50%
= 1.2
Less fixed operating costs 100,000 100,000
Earnings before interest & taxes EBIT 500,000 800,000
+ 60%
Less interest 200,000 200,000
Net profit before taxes 300,000 600,000
Less taxes 40% 120,000 240,000
Net profit after tax 180,000 360,000
Less pref. stock dividends 120,000 120,000 Financial leverage
Earnings available for equity shares 60,000 240,000 + 300%
= =5.0
+ 60%
No. of shares 50,000 50,000
Earnings per share 1.20 4.80
+ 300% Combined leverage
+ 300%
= = 6.0
50%

The table illustrates that as a result of 50% increase in sales (from 20,000 to 30,000 units), the firm
would have a 300% increase in earnings per share (from 1.20 to 4.80). Similarly, a 50%
decrease in sales would conversely, result in a 300% decrease in earnings per share (not shown
in the table). The linear 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. 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.

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