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Management Consulting/MS-04

Question
An analytical statement of altos limited is shown below. it is based on an output(sales) level of 80000 units.

sales          960000
variable cost          560000
revenue before fixed costs   400000
fixed costs          240000
160000

interest          60000
earning before tax          100000
tax          50000
net income          50000

calculate the degree of 1.operating leverage, 2.financial leverage
3. combined leverage, from above data.

Calculate the degrees of (i) operating leverage, (ii) financial leverage and (iii) the combined leverage from the above data.
Ans: Leverage is generally defined as the ratio of the percentage change in profits to the percentage change in sales. In other words, leverage is the multiplying effect that fixed costs have on profits when there is any change in sales. As sales increases or decreases, it is only the variable costs that change correspondingly, fixed costs remain constant.
Operating Leverage
Operating leverage results from the presence of fixed operating costs in a firm's income stream. The extent of the presence of fixed operating costs in a firm's income stream is measured by the degree of operating leverage (DOL).
DOL =   Percentage Change in Earnings Before Interest and Taxes (EBIT)
Percentage Change in Sales
Financial leverage results from the presence of fixed financial costs in a firm's income stream. The extent of the presence of fixed financial costs in a firm's income stream is measured by the degree of financial leverage (DFL).

DFL =   Percentage Change in Net Income (NI)
Percentage Change in Earnings Before Interest and Taxes (EBIT)
Firm's often have both operating and financial leverage. This total or combined leverage results from the presence of both fixed operating and financial costs in a firm's income stream. Combined leverage is measured by the degree of combined leverage (DCL).
DCL =   Percentage Change in Net Income (NI)
Percentage Change in Sales
Notice that DCL = DFL × DOL
Calculation of Operating Leverage, Financial Leverage & Combined Leverage :
EBIT    = ( Sales – Variable cost – Financial Cost )
= ( 9,60,000 – 5,60,000 – 2,40,000 )
= 1,60,000

(a) DOL    = ( Sales – Variable Cost) / EBIT
= ( 9,60,000 – 5,60,000 ) / 1,60,000
= 4,0000 / 1,60,000
= 2.5
(b) DFL   = EBIT / (EBIT – Interest)
= 1,60,000 / (1,60,000 – 60,000)
=  1,60,000 / 1,00,000
=  1.6
(c) DCL   = DOL x DFL
= 2.5 x 1.6
= 4.0

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