The financial leverage (FL) is the relationship between the company’s earnings before interest and taxes or operating profit (OP) and the profit available to shareholders before tax (PBT).
Arvind Ltd. is having the following informations. Calculate financial leverage
opening leverage and combined leverage.
Sales 50,000 units Rs. 10 each
UC Rs. 6 Per Unit
FC Rs. 1,00,000
Interest 8 of 5,00,000
The operating profit (OP) will be calculated using statement of profit as shown below.
Total | Per Unit | |
Units Sold | 50,000 | |
Sales revenue (units sold x price per unit), R s. | 5,00,000 | 10 |
Less: Variable cost (UC), R s. | 3,00,000 | 6 |
Less: Fixed cost (FC), R s. | 1,00,000 | |
Operating profit (OP), R s. | 1,00,000 | |
Less: Interest 8% of 5,00,000 debt, R s. | 40,000 | |
Profit available for shareholders (PBT), R s. | 60,000 |
TotalPer Unit
Financial leverage equals 1.67
FL = 1,00,000/60,000 = 1.67
Calculation of Operating Leverage
The operating leverage (OL) is the ability to use fixed expenses and can be computed contribution margin (CM) divided by operating profit (OP):
The contribution margin (CM) will be calculated using statement of profit as shown below
Total | Per Unit | |
Units Sold | 50,000 | |
Sales revenue (units sold x price per unit), R s. | 5,00,000 | 10 |
Less: Variable cost (UC), R s. | 3,00,000 | 6 |
Contribution margin (CM), R s. | 2,00,000 | 4 |
OL = 2,00,000/1,00,000 = 2.00
Operational leverage equals 2.00
Calculation of Combined Leverage
The combined leverage (CM) shows the relationship between the company’s sales (CM) and profit before tax (PBT). The combined leverage is calculated using the two formulas:
CM = 1.67 x 2.00 =3.33 or CM = 2,00,000/60,000 =3.33
Combined leverage equals 3.33