Page 154 - DMGT405_FINANCIAL%20MANAGEMENT

Financial Management

Notes 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



Case Study Case: RKV – Leverage

his case provides the reader with the opportunity to apply different concepts of leverage
Tto 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.
Most of RKV’s financial planning is done by George Lee, GM of finance. Lee has recently
prepared financial statements estimating next year’s operating results. He believes that,
the firm will earn just over $800,000 in the current year on sales of $8 million and is
forecasting sales of $13 million next year. It is likely, that variable costs will remain at
approximately the same percentage of sales next year as this year. Fixed costs will probably
rise to 12 per cent next year.
Company A has an EBIT of $2.6 million, no debt, $8 in equity (300,000 shares), $18 million.
Company B has the same level of sales, an EBIT of $2.85 million, $3.3 and sales of debt at
11 per cent, and $8 in equity (300,000 shares). The tax rate is 35 per cent.
RKV has been investigating the addition of a number of new product lines to be sold
through its existing distribution channels. Two items have been of particular interest. The
first would involve the production and sale of chaise lounges for use around swimming
pools. The product would be aimed at commercial users, such as hotels, but could be sold
through hardware and discount stores as a residential product. The second new item
would be a patio umbrella. The umbrella would be a large, 12-rib, multicolored canvas
with fringe and would be aimed at the residential market. Both products would fit in with
RKV’s existing product line and neither would require any increase in networking capital.
Contd...

148 LOVELY PROFESSIONAL UNIVERSITY