Estimate and interpret the degree of operating, financial, and combined leverage of A Ltd. And B. Ltd. based on the following data:
A Ltd. (Rs.) B Ltd. (Rs.)
Sales 16,00,000 20,00,000
Fixed Costs 5,00,000 10,00,000
Variable expenses are 40% of sales for firm A and 25% for firm B. Interest expenses are ₹ 1,60,000 for A Ltd. and ₹ 2,00,000 for B Ltd.
To estimate and interpret the degree of operating, financial, and combined leverage of A Ltd. and B Ltd., we need to calculate the relevant leverage ratios.
1. Degree of Operating Leverage (DOL):
DOL measures the sensitivity of operating profit to changes in sales revenue.
DOL = Contribution Margin / Operating Profit
For A Ltd.:
Sales = Rs. 16,00,000
Variable Expenses = 40% of Sales = 0.4 * 16,00,000 = Rs. 6,40,000
Contribution Margin = Sales - Variable Expenses = 16,00,000 - 6,40,000 = Rs. 9,60,000
DOL (A Ltd.) = 9,60,000 / Operating Profit (A Ltd.)
For B Ltd.:
Sales = Rs. 20,00,000
Variable Expenses = 25% of Sales = 0.25 * 20,00,000 = Rs. 5,00,000
Contribution Margin = Sales - Variable Expenses = 20,00,000 - 5,00,000 = Rs. 15,00,000
DOL (B Ltd.) = 15,00,000 / Operating Profit (B Ltd.)
2. Degree of Financial Leverage (DFL):
DFL measures the sensitivity of earnings per share (EPS) to changes in operating profit.
DFL = Earnings Before Interest and Taxes (EBIT) / Earnings Before Taxes (EBT)
For A Ltd.:
EBIT (A Ltd.) = Operating Profit (A Ltd.) - Interest Expenses (A Ltd.) = Operating Profit (A Ltd.) - Rs. 1,60,000
EBT (A Ltd.) = EBIT (A Ltd.) - Taxes (Assuming it to be zero)
DFL (A Ltd.) = EBIT (A Ltd.) / EBT (A Ltd.)
For B Ltd.:
EBIT (B Ltd.) = Operating Profit (B Ltd.) - Interest Expenses (B Ltd.) = Operating Profit (B Ltd.) - Rs. 2,00,000
EBT (B Ltd.) = EBIT (B Ltd.) - Taxes (Assuming it to be zero)
DFL (B Ltd.) = EBIT (B Ltd.) / EBT (B Ltd.)
3. Degree of Combined Leverage (DCL):
DCL measures the sensitivity of EPS to changes in sales revenue.
DCL = DOL * DFL
Interpretation:
- The degree of operating leverage (DOL) measures how fixed costs and variable costs impact the operating profit.
- The degree of financial leverage (DFL) measures how interest expenses impact the earnings before taxes (EBT).
- The degree of combined leverage (DCL) measures the combined effect of operating and financial leverage on earnings per share (EPS).
By calculating these ratios, we can determine the leverage position of A Ltd. and B Ltd.