OPERATING
AND FINANCIAL
LEVERAGE
LEVERAGE – represents the use of fixed costs items
to magnify the firm’s results.
LEVERAGE IN BUSINESS
two primary decisions :
* You must determine the amount of fixed cost
plant and equipment you wish to use in then
production process.
* You must determine how will you finance the
business.
CVP ANALYSIS (COST-VOLUME-PROFIT)
- Is a powerful tool and vital in many business decisions
because it helps managers understand the relationships
among cost, volume and profit.
- focused on how the profits are affected by the following
elements:
a) selling prices
b) sales volume
c) unit variables costs
d) total fixed costs and
e) mix of products sold
CONTRIBUTION MARGIN PER UNIT OR MARGINAL
INCOME PER UNIT
- this is the excess of unit selling price over unit variable
costs and the amount each unit sold contributes
toward.
1) Covering fixed costs
2) Providing operating profits
FORMULA :
CM per unit = Unit selling price – unit variable costs
CONTRIBUTION MARGIN RATIO
Sales P
P100,000 P110,000 P100,000 110,000
Variable Expenses
60,000 66,000 30,000 33,000
Contribution Margin
40,000 44,000 70,000 77,000
Fixed Expenses
30,000 30,000 60,000 60,000
Net Operating
Income P10,000 14,000 10,000 17,000
Degree of operating leverage
FORMULA ;
Solution :
Formula method :
• Reflects the amount of debt used in the capital structures of the firm.
• It is helpful to think of operating leverage as primarily affecting the left
hand side of the statement of financial position and financial leverage as
affecting the right hand side.
Statement of Financial Position
ASSET LIABILITIES AND OWNER’S EQUITY
Operating Leverage Financial Leverage
IMPACT ON EARNINGS
we shall examine two financial plans for a firm, each
employing a significantly different amount of debt in the
capital structure. Financing totaling P200,000 is required to
carry the assets of the firm.
TOTAL ASSETS – P200,000
Plan A Plan B
(Leveraged) (Conservative)
Debt ( 8% P150,000 (P12,000 interest) P50,000(P4,000 interest)
interest)
Common (8,000 shares at (24,000 shares at
stock 50,000 P6.25) 150,000 P6.25)
Total Financing P 200,000 P200,000
DEGREE OF FINANCIAL LEVERAGE
lets compute the degree of financial leverage for Plan A and Plan B at an EBIT
level of P 36,000. Plan A calls for P 12,000 of interest at all levels of financing,
and Plan B requires P4,000.
• Plan A ( Leveraged)
DFL = EBIT = P36,000 = P36,000 = 1.5
EBIT – 1 P36,000 – P12,000 P24,000
• Plan B (Conservative)
DFL = EBIT = P36,000 = P36,000 =1.1
EBIT – 1 P36,000 – P4,000 P32,000
LIMITATIONS TO USE OF FINANCIAL LEVERAGE
• We may quickly observe that if debt such a good thing, why sell any stock? With
exclusive debt financing at an EBIT level of P 36,000, we would have agree of
financial leverage factor (DFL) of 1.8.
With no stock , we would borrow the full P200,000. (8% X P200,000 = P16,000
interest )
COMBINING OPERATING AND FINANCIAL LEVERAGE
• DEGREE OF COMBINED LEVERAGE ( DCL) use the entire income statement
shows the impact of a change in sales or volume on bottom-line earnings
per share. Degree of operating and financial leverage is in effect, being
combined.