Page 175 - DMGT207_MANAGEMENT_OF_FINANCES

Management of Finances

Notes Question
What would be the effect of acceptance of each project on leverages? Would it give a
favourable financial leverage to RKV?

RKV Income Statement (Projected through December 31 this Year)

EBIT 1,926,520
EBT 1,536,520
Fixed Costs 1,043,480
Interest 390,000
Marginal contribution 2,970,000
Net Income 1,027,303
Sales $ 8,000,000
Taxes 509,217
Variable Costs 5,030,000

7.5 Summary

 In financial analysis, leverage represents the influence of one financial variable over some
other related financial variables.
 The amount of leverage in the firm’s capital structure can significantly affect its value by
affecting returns and risks.

 Operating leverage is concerned with the relationship between the firm’s sales revenue
and its earnings before interest and taxes, or EBIT

Operating leverage =

 Break-even analysis, sometimes called cost volume profit analysis, is used by the firm to
determine the level of operations necessary to cost all operating costs.

 High operating leverage is good when revenues are rising and bad when they are falling.
 The financial leverage is favourable when the firm earns more on the investments/assets
financed by the sources having fixed charges.

Financial leverage =

 Combined leverage or total leverage can be defined as potential use of fixed costs, both
operating and financial, to magnify the effect of changes in sales on the firms, earnings per
share.
Combined leverage = operating leverage × financial leverage.

7.6 Keywords

Debt: It is that which is owed; usually referencing assets owed.

Degree of Operating Leverage: It is the change in the percentage of operating income (EBIT) for
the change in percentage of sales revenue.

170 LOVELY PROFESSIONAL UNIVERSITY