4) (a) What is operating leverage and financial leverage? What is their significance? (b) Firm ‘A’ has a annual sale of Rs 80,00,000 and variable cost is Rs 50,00,000. Fixed cost is Rs 5,00,000 per year. Company has 11% debentures of Rs 30,00,000. Find out operating leverage and financial leverage of the firm.

 

TUTOR MARKED ASSIGNMENT 

COURSE CODE : MCO-07 

COURSE TITLE : Financial Managements 

ASSIGNMENT CODE : MCO-07/TMA/2022-2023 

COVERAGE : ALL BLOCKS 

4) (a) What is operating leverage and financial leverage? What is their significance?

(b) Firm ‘A’ has a annual sale of Rs 80,00,000 and variable cost is Rs 50,00,000. Fixed cost is Rs 5,00,000 per year. Company has 11% debentures of Rs 30,00,000. Find out operating leverage and financial leverage of the firm.

Answer a) 

Operating leverage and financial leverage are two concepts that are essential for understanding the financial performance of a company. Both of these concepts are used to determine how much debt a company is carrying and how it is affecting the company's financial performance.

Operating leverage refers to the degree to which a company's fixed costs affect its profitability. Fixed costs are costs that do not change with changes in the level of output or sales. Examples of fixed costs include rent, salaries, and insurance. When a company has high fixed costs, it has a high operating leverage. This means that changes in sales will have a significant impact on the company's profitability. For example, if a company has a high operating leverage, a 10% increase in sales may result in a 20% increase in profits.

On the other hand, if a company has low fixed costs, it has a low operating leverage. This means that changes in sales will have a smaller impact on the company's profitability. For example, if a company has a low operating leverage, a 10% increase in sales may result in only a 5% increase in profits.

Financial leverage refers to the degree to which a company is using debt to finance its operations. When a company uses debt to finance its operations, it is said to be leveraged. The degree to which a company is leveraged is measured by its debt-to-equity ratio. This ratio compares the amount of debt a company has to the amount of equity it has.

A company with a high debt-to-equity ratio is said to have high financial leverage. This means that a large portion of the company's operations is financed through debt. High financial leverage can be beneficial for a company because it allows it to take advantage of tax deductions on interest payments. However, it also means that the company has a higher risk of defaulting on its debt payments.

A company with a low debt-to-equity ratio is said to have low financial leverage. This means that the company relies more on equity to finance its operations. While this may be safer for the company, it also means that it may miss out on the tax advantages of using debt.

Here are some key points to keep in mind about operating leverage and financial leverage:

Operating leverage:

Refers to the degree to which a company's fixed costs affect its profitability.

Companies with high operating leverage will see larger changes in profits as sales increase or decrease.

Companies with low operating leverage will see smaller changes in profits as sales increase or decrease.

Financial leverage:

Refers to the degree to which a company is using debt to finance its operations.

Companies with high financial leverage have a higher risk of defaulting on their debt payments.

Companies with low financial leverage may miss out on the tax advantages of using debt.

It is important for investors to understand a company's operating leverage and financial leverage when evaluating its financial performance. Both of these concepts can have a significant impact on a company's profitability and risk profile. By understanding these concepts, investors can make more informed decisions about which companies to invest in.

The significance of operating leverage and financial leverage lies in their ability to affect a company's financial performance and risk profile.

Operating leverage is significant because it can impact a company's profitability. Companies with high operating leverage will see larger changes in profits as sales increase or decrease, making them more sensitive to changes in the market. This means that companies with high operating leverage may experience higher profits during periods of growth, but may also see larger losses during periods of decline.

Financial leverage is significant because it can impact a company's ability to meet its debt obligations. Companies with high financial leverage have a higher risk of defaulting on their debt payments, which can lead to bankruptcy and other financial difficulties. However, using debt can also have tax advantages, making it an attractive option for companies looking to finance their operations.

In addition to affecting a company's financial performance, operating leverage and financial leverage can also impact a company's risk profile. Companies with high operating leverage and high financial leverage are generally considered to be riskier investments than companies with low leverage. This is because they are more sensitive to changes in the market and have a higher risk of defaulting on their debt obligations.

Investors should be aware of a company's operating leverage and financial leverage when evaluating its financial performance and risk profile. By understanding these concepts, investors can make more informed decisions about which companies to invest in and how much risk they are willing to take on. It is also important for companies to manage their operating leverage and financial leverage carefully to ensure that they are not taking on too much risk or missing out on potential opportunities for growth.

Answer b)

To calculate the operating leverage, we need to use the following formula:

Operating Leverage = Contribution Margin / Operating Income

Where,

Contribution Margin = Sales - Variable Costs

Operating Income = Sales - Variable Costs - Fixed Costs

Given,

Annual Sales = Rs 80,00,000

Variable Costs = Rs 50,00,000

Fixed Costs = Rs 5,00,000

Contribution Margin = Rs 80,00,000 - Rs 50,00,000 = Rs 30,00,000

Operating Income = Rs 80,00,000 - Rs 50,00,000 - Rs 5,00,000 = Rs 25,00,000

Operating Leverage = Rs 30,00,000 / Rs 25,00,000 = 1.2

To calculate the financial leverage, we need to use the following formula:

Financial Leverage = EBIT / EBT

Where,

EBIT = Earnings Before Interest and Taxes

EBT = Earnings Before Taxes

Given,

EBIT = Operating Income = Rs 25,00,000

Now, we need to calculate EBT. To do this, we need to subtract the interest expense from the EBIT.

Interest Expense = 11% of Rs 30,00,000 = Rs 3,30,000

EBT = EBIT - Interest Expense = Rs 25,00,000 - Rs 3,30,000 = Rs 21,70,000

Financial Leverage = Rs 25,00,000 / Rs 21,70,000 = 1.15

Therefore, the operating leverage of the firm is 1.2 and the financial leverage of the firm is 1.15.